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curve map to find her utility-maximizing consumption 791 bundle, given her budget constraint, which arises because she must choose a consumption bundle that costs no more than her total income. It’s important to understand how our analysis here relates to what we did in Module 51. We are not offering a new theory of consumer behavior in this module—consumers are assumed to maximize total utility as before. In particular, we know that consumers will follow the optimal consumption rule: the optimal consumption bundle lies on the budget line, and the marginal utility per dollar is the same for every good in the bundle. But as we’ll see shortly, we can derive this optimal consumer behavior in a somewhat different way—a way that yields deeper insights into consumer choice. The Marginal Rate of Substitution The first element of our approach is a new concept, the marginal rate of substitution. The essence of this concept is illustrated in Figure 80.5. f i g u r e 80.5 The Changing Slope of an Indifference Curve Quantity of restaurant meals 30 20 15 12 10 0 Ingrid trades 10 restaurant meals...... for 1 room. V –10 W +1 Ingrid trades 2 restaurant meals... X Y –2... for 1 room. Z +1 I 2 3 4 5 6 Quantity of rooms Consumption bundle Quantity of rooms Quantity of restaurant meals 30 20 15 12 10 This indifference curve is downward sloping and convex, implying that restaurant meals and rooms are ordinary goods for Ingrid. As Ingrid moves down her indifference curve from V to Z, she trades reduced consumption of restaurant meals for increased consumption of housing. However, the terms of that trade-off change. As she moves from V to W, she is willing to give up 10 restaurant meals in return for 1 more room. As her consumption of rooms rises and her consumption of restaurant meals falls, she is willing to give up fewer restaurant meals in return for each additional room. The flattening of the slope as you move from left to right arises from diminishing marginal utility. We have just seen that for most goods, consumers’ indifference curves are downward sloping and convex. Figure 80.5 shows such an indifference curve. The points labeled V, W, X, Y, and Z all lie on this indifference curve—that is, they represent consumption bundles that yield Ingrid the same level of total utility. The table accompanying the figure shows the components of each of the bundles. As we move along the
indifference curve from V to Z, Ingrid’s consumption of housing steadily increases from 2 rooms to 6 rooms, her consumption of restaurant meals steadily decreases from 30 meals to 10 meals, and her total utility is kept constant. As we move down the indifference curve, then, Ingrid is trading more of one good for less of the other, with the 792 terms of that trade-off—the ratio of additional rooms consumed to restaurant meals sacrificed—chosen to keep her total utility constant. Notice that the quantity of restaurant meals that Ingrid is willing to give up in return for an additional room changes along the indifference curve. As we move from V to W, housing consumption rises from 2 to 3 rooms and restaurant meal consumption falls from 30 to 20—a trade-off of 10 restaurant meals for 1 additional room. But as we move from Y to Z, housing consumption rises from 5 to 6 rooms and restaurant meal consumption falls from 12 to 10, a trade-off of only 2 restaurant meals for an additional room. To put it in terms of slope, the slope of the indifference curve between V and W is −10: the change in restaurant meal consumption, −10, divided by the change in housing consumption, 1. Similarly, the slope of the indifference curve between Y and Z is −2. So the indifference curve gets flatter as we move down it to the right—that is, it has a convex shape, one of the four properties of an indifference curve for ordinary goods. Why does the trade-off change in this way? Let’s think about it intuitively and then work through it more carefully. When Ingrid moves down her indifference curve, whether from V to W or from Y to Z, she gains utility from her additional consumption of housing but loses an equal amount of utility from her reduced consumption of restaurant meals. But at each step, the initial position from which Ingrid begins is different. At V, Ingrid consumes only a small quantity of rooms; because of diminishing marginal utility, her marginal utility per room at that point is high. At V, then, an additional room adds a lot to Ingrid’s total utility. But at V she already consumes a large quantity of restaurant meals, so her marginal utility of restaurant meals is low at that point. This means that it takes a large reduction in her quantity of restaurant meals consumed to offset the increased utility she gets from the extra room of housing. At Y, in contrast, Ingrid consumes a much larger
quantity of rooms and a much smaller quantity of restaurant meals than at V. This means that an additional room adds fewer utils, and a restaurant meal forgone costs more utils, than at V. So Ingrid is willing to give up fewer restaurant meals in return for another room of housing at Y (where she gives up 2 meals for 1 room) than she is at V (where she gives up 10 meals for 1 room). Now let’s express the same idea—that the trade-off Ingrid is willing to make depends on where she is starting from—by using a little math. We do this by examining how the slope of the indifference curve changes as we move down it. Moving down the indifference curve—reducing restaurant meal consumption and increasing housing consumption—will produce two opposing effects on Ingrid’s total utility: lower restaurant meal consumption will reduce her total utility, but higher housing consumption will raise her total utility. And since we are moving down the indifference curve, these two effects must exactly cancel out: Along the indifference curve: (80-1) (Change in total utility due to lower restaurant meal consumption) + (Change in total utility due to higher housing consumption) = 0 or, rearranging terms, Along the indifference curve: (80-2) −(Change in total utility due to lower restaurant meal consumption) = (Change in total utility due to higher housing consumption) Let’s now focus on what happens as we move only a short distance down the indifference curve, trading off a small increase in housing consumption in place of a small decrease in restaurant meal consumption. Following our notation from before, let’s use MUR and MUM to represent the marginal utility of rooms and restaurant meals, respectively, and Q R and Q M to represent the changes in room and meal consumption 793 The marginal rate of substitution, or MRS, of good R in place of good M is equal to MUR MUM, the ratio of the marginal utility of R to the marginal utility of M. respectively. In general, the change in total utility caused by a small change in consumption of a good is equal to the change in consumption multiplied by the marginal utility of that good. This means that we can calculate the change in Ingrid’s total utility generated by a change in her consumption bundle using the following equations: (80-3) Change in total utility due to a change in restaurant meal consumption = MUM × Q M and (80-4) Change in total
utility due to a change in housing consumption = MUR × Q R So we can write Equation 80-2 in symbols as: Along the indifference curve: (80-5) −MUM × Q M = MUR × Q R Note that the left-hand side of Equation 80-5 has a negative sign; it represents the loss in total utility from decreased restaurant meal consumption. This must equal the gain in total utility from increased room consumption, represented by the right-hand side of the equation. What we want to know is how this translates into the slope of the indifference curve. To find the slope, we divide both sides of Equation 80-5 by Q R, and again by −MUM, in order to get the Q M, Q R terms on one side and the MUR, MUM terms on the other. This results in: (80-6) Along the indifference curve: ΔQM ΔQ R = − MUR MUM The left-hand side of Equation 80-6 is the slope of the indifference curve; it is the rate at which Ingrid is willing to trade rooms (the good on the horizontal axis) for restaurant meals (the good on the vertical axis) without changing her total utility level. The righthand side of Equation 80-6 is the negative of the ratio of the marginal utility of rooms to the marginal utility of restaurant meals—that is, the ratio of what she gains from one more room to what she gains from one more meal, with a negative sign in front. Putting all this together, Equation 80-6 shows that, along the indifference curve, the quantity of restaurant meals Ingrid is willing to give up in return for a room, ΔQM ΔQ R, is exactly equal to the negative of the ratio of the marginal utility of a room to that of a meal, −. Only when this condition is met will her total utility level remain con- MUR MUM stant as she consumes more rooms and fewer restaurant meals. Economists have a special name for the ratio of the marginal utilities found in the right-hand side of Equation 80-6: it is called the marginal rate of substitution, or MRS, of rooms (the good on the horizontal axis) in place of restaurant meals (the good on the vertical axis). That’s because as we slide down Ingrid’s indifference curve, we are substituting more rooms for fewer restaurant meals in her consumption bundle. As we
’ll see shortly, the marginal rate of substitution plays an important role in finding the optimal consumption bundle. Recall that indifference curves get flatter as you move down them to the right. The reason, as we’ve just discussed, is diminishing marginal utility: as Ingrid consumes more housing and fewer restaurant meals, her marginal utility from housing falls and her marginal utility from restaurant meals rises. So her marginal rate of substitution, which is equal to the negative of the slope of her indifference curve, falls as she moves down the indifference curve. 794 The principle of diminishing marginal rate of substitution states that the more of good R a person consumes in proportion to good M, the less M he or she is willing to substitute for another unit of R. Two goods, R and M, are ordinary goods in a consumer’s utility function when (1) the consumer requires additional units of R to compensate for fewer units of M, and vice versa; and (2) the consumer experiences a diminishing marginal rate of substitution when substituting one good for another. The flattening of indifference curves as you slide down them to the right—which reflects the same logic as the principle of diminishing marginal utility—is known as the principle of diminishing marginal rate of substitution. It says that an individual who consumes only a little bit of good A and a lot of good B will be willing to trade off a lot of good B in return for one more unit of good A, and an individual who already consumes a lot of good A and not much of good B will be less willing to make that trade-off. We can illustrate this point by referring back to Figure 80.5. At point V, a bundle with a high proportion of restaurant meals to rooms, Ingrid is willing to forgo 10 restaurant meals in return for 1 room. But at point Y, a bundle with a low proportion of restaurant meals to rooms, she is willing to forgo only 2 restaurant meals in return for 1 room. From this example we can see that, in Ingrid’s utility function, rooms and restaurant meals possess the two additional properties that characterize ordinary goods. Ingrid requires additional rooms to compensate her for the loss of a meal, and vice versa; so her indifference curves for these two goods slope downward. And her indifference curves are convex: the slope of her indifference curve—the negative of the marginal rate of substitution—becomes flatter as we move down it. In fact, an indifference curve is convex only when it has a
diminishing marginal rate of substitution—these two conditions are equivalent. With this information, we can define ordinary goods, which account for the great majority of goods in any consumer’s utility function. A pair of goods are ordinary goods in a consumer’s utility function if they possess two properties: the consumer requires more of one good to compensate for less of the other, and the consumer experiences a diminishing marginal rate of substitution when substituting one good for the other. Next we will see how to determine Ingrid’s optimal consumption bundle using in- difference curves. The Tangency Condition Now let’s put some of Ingrid’s indifference curves on the same diagram as her budget line to illustrate an alternative way of representing her optimal consumption choice. Figure 80.6 shows Ingrid’s budget line, BL, when her income is $2,400 per month, f i g u r e 80.6 The Optimal Consumption Bundle The budget line, BL, shows Ingrid’s possible consumption bundles, given an income of $2,400 per month, when rooms cost $150 per month and restaurant meals cost $30 each. I1, I2, and I3 are indifference curves. Consumption bundles such as B and C are not optimal because Ingrid can move to a higher indifference curve. The optimal consumption bundle is A, where the budget line is just tangent to the highest possible indifference curve. Quantity of restaurant meals 80 70 60 50 40 30 20 10 0 B A Optimal consumption bundle I3 I2 C I1 BL 2 4 6 8 10 12 14 16 Quantity of rooms 795 The tangency condition between the indifference curve and the budget line holds when the indifference curve and the budget line just touch. This condition determines the optimal consumption bundle when the indifference curves have the typical convex shape. housing costs $150 per room each month, and restaurant meals cost $30 each. What is her optimal consumption bundle? To answer this question, we show several of Ingrid’s indifference curves: I1, I2, and I3. Ingrid would like to achieve the total utility level represented by I3, the highest of the three curves, but she cannot afford to because she is constrained by her income: no consumption bundle on her budget line yields that much total utility. But she shouldn’t settle for the level of total utility generated by B, which lies on I1: there are other bundles on her budget line, such as A, that
clearly yield higher total utility than B. In fact, A—a consumption bundle consisting of 8 rooms and 40 restaurant meals per month—is Ingrid’s optimal consumption choice. The reason is that A lies on the highest indifference curve Ingrid can reach given her income. At the optimal consumption bundle A, Ingrid’s budget line just touches the relevant indifference curve—the budget line is tangent to the indifference curve. This tangency condition between the indifference curve and the budget line applies to the optimal consumption bundle when the indifference curves have the typical convex shape. To see why, let’s look more closely at how we know that a consumption bundle that doesn’t satisfy the tangency condition can’t be optimal. Re examining Figure 80.6, we can see that consumption bundles B and C are both affordable because they lie on the budget line. However, neither is optimal. Both of them lie on the indifference curve I1, which cuts through the budget line at both points. But because I1 cuts through the budget line, Ingrid can do better: she can move down the budget line from B or up the budget line from C, as indicated by the arrows. In each case, this allows her to get onto a higher indifference curve, I2, which increases her total utility. Ingrid cannot, however, do any better than I2: any other indifference curve either cuts through her budget line or doesn’t touch it at all. And the bundle that allows her to achieve I2 is, of course, her optimal consumption bundle. The Slope of the Budget Line Figure 80.6 shows us how to use a graph of the budget line and the indifference curves to find the optimal consumption bundle, the bundle at which the budget line and the indifference curve are tangent. But rather than rely on drawing graphs, we can determine the optimal consumption bundle by using a bit more math. As you can see from Figure 80.6, at A, the optimal consumption bundle, the budget line and the indifference curve have the same slope. Why? Because two curves can only be tangent to each other if they have the same slope at the point where they meet. Otherwise, they would cross each other at that point. And we know that if we are on an indifference curve that crosses the budget line (like I1, in Figure 80.6), we can’t be on the indifference curve that contains the optimal consumption bundle (like I2). So we can
use information about the slopes of the budget line and the indifference curve to find the optimal consumption bundle. To do that, we must first analyze the slope of the budget line, a fairly straightforward task. We know that Ingrid will get the highest possible utility by spending all of her income and consuming a bundle on her budget line. So we can represent Ingrid’s budget line, the consumption bundles available to her when she spends all of her income, with the equation: (80-7) (QR × PR) + (QM × PM) = N where N stands for Ingrid’s income. To find the slope of the budget line, we divide its vertical intercept (where the budget line hits the vertical axis) by its horizontal intercept (where it hits the horizontal axis) and then add a negative sign. The vertical intercept is the point at which Ingrid spends all her income on restaurant meals and none on housing (that is, QR = 0). In that case the number of restaurant meals she consumes is: (80-8) Q M = N PM = $2,400/($30 per meal) = 80 meals = Vertical intercept of budget line 796 At the other extreme, Ingrid spends all her income on housing and none on restaurant meals (so that QM = 0). This means that at the horizontal intercept of the budget line, the number of rooms she consumes is: The relative price of good R in terms of good M is equal to PR PM, the rate at which R trades for M in the market. (80-9) Q R = = N PR $2,400 ($150 per room) = Horizontal intercept of budget line = 16 rooms Now we have the information needed to find the slope of the budget line. It is: (80-10) Slope of budget line = − (Vertical intercept) (Horizontal intercept) = − N PM N PR = − PR PM Notice the negative sign in Equation 80-10; it’s there because the budget line slopes downward. The quantity is known as the relative price of rooms in terms of restau- PR PM rant meals, to distinguish it from an ordinary price in terms of dollars. Because buying PR PM one more room requires Ingrid to give up the quantity of restaurant meals, or 5 meals, we can interpret the relative price PR PM restaurant meals in the market; it is the price—in terms of restaurant meals—Ingrid has to “pay”
to get one more room. as the rate at which a room trades for Looking at this another way, the slope of the budget line—the negative of the relative price—tells us the opportunity cost of each good in terms of the other. The relative price illustrates the opportunity cost to an individual of consuming one more unit of one good in terms of how much of the other good in his or her consumption bundle must be forgone. This opportunity cost arises from the consumer’s limited resources— his or her limited budget. It’s useful to note that Equations 80-8, 80-9, and 80-10 give us all the information we need about what happens to the budget line when relative price or income changes. From Equations 80-8 and 80-9 we can see that a change in income, N, leads to a parallel shift of the budget line: both the vertical and horizontal intercepts will shift. That is, how far out the budget line is from the origin depends on the consumer’s income. If a consumer’s income rises, the budget line moves outward. If the consumer’s income shrinks, the budget line shifts inward. In each case, the slope of the budget line stays the same because the relative price of one good in terms of the other does not change. In contrast, a change in the relative price will lead to a change in the slope of the PR PM budget line. We’ll analyze these changes in the budget line and how the optimal consumption bundle changes when the relative price changes or when income changes in greater detail later in the module. Prices and the Marginal Rate of Substitution Now we’re ready to bring together the slope of the budget line and the slope of the indifference curve to find the optimal consumption bundle. From Equation 80-6, we know that the slope of the indifference curve at any point is equal to the negative of the marginal rate of substitution: (80-11) Slope of indifference curve = − MUR MUM As we’ve already noted, at the optimal consumption bundle the slope of the budget line and the slope of the indifference curve are equal. We can write this formally by putting 797 The relative price rule says that at the optimal consumption bundle, the marginal rate of substitution between two goods is equal to their relative price. Equations 80-10 and 80-11 together, which gives us the relative price rule for finding the optimal consumption bundle: (80-12
) At the optimal consumption bundle: − MUR MUM = PR PM or, cancelling the negative signs, MUR MUM = PR PM That is, at the optimal consumption bundle, the marginal rate of substitution between any two goods is equal to the ratio of their prices. To put it in a more intuitive way, starting with Ingrid’s optimal consumption bundle, the rate at which she would trade a room for more restaurant meals along her indifference curve,, is equal to the rate at which rooms are traded for restaurant meals in the market, MUR MUM PR PM. What would happen if this equality did not hold? We can see by examining Figure MUR MUM 80.7. There, at point B, the slope of the indifference curve, −, is greater in absolute. This means that, at B, Ingrid values an ad- value than the slope of the budget line, − PR PM ditional room in place of meals more than it costs her to buy an additional room and forgo some meals. As a result, Ingrid would be better off moving down her budget line toward A, consuming more rooms and fewer restaurant meals—and because of that, B could not have been her optimal bundle! Likewise, at C, the slope of Ingrid’s indifference curve is less in absolute value than the slope of the budget line. The implication is that, at C, Ingrid values additional meals in place of a room more than it costs her to buy additional meals and forgo a room. Again, Ingrid would be better off moving along her budget line—consuming more restaurant meals and fewer rooms—until she reaches A, her optimal consumption bundle. But suppose we transform the last term of Equation 80-12 in the following way: divide both sides by PR and multiply both sides by MUM. Then the relative price rule becomes the optimal consumption rule: f i g u r e 80.7 Understanding the Relative Price Rule The relative price of rooms in terms of restaurant meals is equal to the negative of the slope of the budget line. The marginal rate of substitution of rooms for restaurant meals is equal to the negative of the slope of the indifference curve. The relative price rule says that at the optimal consumption bundle, the marginal rate of substitution must equal the relative price. This point can be demonstrated by considering what happens when the marginal rate of substitution is not equal to the relative price. At consumption bundle B, the marginal rate of substitution is larger than the relative price;
Ingrid can increase her total utility by moving down her budget line, BL. At C, the marginal rate of substitution is smaller than the relative price, and Ingrid can increase her total utility by moving up the budget line. Only at A, where the relative price rule holds, is her total utility maximized, given her budget constraint. Quantity of restaurant meals 80 70 60 50 40 30 20 10 0 B A At the optimal consumption bundle, MRS is equal to the relative price. C I2 I1 BL 2 4 6 8 10 12 14 16 Quantity of rooms 798 80-13) Optimal consumption rule: MUR PM = MUM PM So using either the optimal consumption rule or the relative price rule, we find the same optimal consumption bundle. Preferences and Choices Now that we have seen how to represent the optimal consumption choice in an indifference curve diagram, we can turn briefly to the relationship between consumer preferences and consumer choices. When we say that two consumers have different preferences, we mean that they have different utility functions. This in turn means that they will have indifference curve maps with different shapes. And those different maps will translate into different consumption choices, even among consumers with the same income and who face the same prices. To see this, suppose that Ingrid’s friend Lars also consumes only housing and restaurant meals. However, Lars has a stronger preference for restaurant meals and a weaker preference for housing. This difference in preferences is shown in Figure 80.8 80.8 Differences in Preferences Ingrid and Lars have different preferences, reflected in the different shapes of their indifference curve maps. So they will choose different consumption bundles even when they have the same possible choices. Each has an income of $2,400 per month and faces prices of $30 per meal and $150 per room. Panel (a) shows Ingrid’s consumption choice: 8 rooms and 40 restaurant meals. Panel (b) shows Lars’s choice: even though he has the same budget line, he consumes fewer rooms and more restaurant meals. Quantity of restaurant meals 80 70 60 50 40 30 20 10 0 Quantity of restaurant meals 80 70 60 50 40 30 20 10 0 (a) Ingrid’s Preferences and Her Optimal Consumption Bundle Ingrid’s optimal consumption bundle I3 I2 I1 BL 2 4 6 8 10 12 14 16 Quantity of rooms (b) Lars’s Preferences and His Optimal Consumption Bundle Lars’s optimal consumption bundle I3 I2 I1 BL 2 4
6 8 10 12 14 16 Quantity of rooms 799 which shows two sets of indifference curves: panel (a) shows Ingrid’s preferences and panel (b) shows Lars’s preferences. Note the difference in their shapes. Suppose, as before, that rooms cost $150 per month and restaurant meals cost $30. Let’s also assume that both Ingrid and Lars have incomes of $2,400 per month, giving them identical budget lines. Nonetheless, because they have different preferences, they will make different consumption choices, as shown in Figure 80.8. Ingrid will choose 8 rooms and 40 restaurant meals; Lars will choose 4 rooms and 60 restaurant meals. M o d u l e 80 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. The accompanying table shows Samantha’s preferences for consumption bundles composed of chocolate kisses and licorice drops. Consumption bundle A B C D Quantity of chocolate kisses 1 2 3 2 Quantity of licorice drops 3 3 1 1 Total utility (utils) 6 10 6 4 a. With chocolate kisses on the horizontal axis and licorice drops on the vertical axis, draw hypothetical indifference curves for Samantha and locate the bundles on the curves. Assume that both items are ordinary goods. b. Suppose you don’t know the number of utils provided by each bundle. Assuming that more is better, predict Samantha’s ranking of each of the four bundles to the extent possible. Explain your answer. Tackle the Test: Multiple-Choice Questions 1. Which of the following is true along an individual’s indifference curve for ordinary goods? a. The slope is constant. b. Total utility changes. c. The individual is indifferent between any two points. d The slope is equal to the ratio of the prices of the consumption bundles. e. The individual doesn’t care if utility is maximized. 2. Which of the following is/are true of indifference curves for ordinary goods? I. They cannot intersect. II. They have a negative slope. III. They are convex. 2. On the left diagram in panel (a) of Figure 80.4, draw a point B anywhere on the 200-util indifference curve and a point C anywhere on the 100-util indifference curve (but not at the same location as point A). By comparing the utils generated by bundles A and B and those generated by bundles A and C, explain why indifference curves cannot cross
. 3. Lucinda and Kyle each consume 3 comic books and 6 video games. Lucinda’s marginal rate of substitution of books for games is 2 and Kyle’s is 5. a. For each person, find another consumption bundle that yields the same total utility as the current bundle. Who is less willing to trade games for books? In a diagram with books on the horizontal axis and games on the vertical axis, how would this be reflected in differences in the slopes of their indifference curves at their current consumption bundles? b. Find the relative price of books in terms of games at which Lucinda’s current bundle is optimal. Is Kyle’s bundle optimal given this relative price? If not, how should Kyle rearrange his consumption? a. I only b. II only c. III only d. I and II only I, II, and III e. 3. Moving from left to right along an indifference curve, which of the following increases? a. The marginal utility of the vertical axis good b. The marginal utility of the horizontal axis good c. The absolute value of the slope d. The marginal rate of substitution e. The demand for the vertical axis good 800. If the quantity of good X is measured on the horizontal axis and 5. If the quantity of good X is again measured on the the quantity of good Y is measured on the vertical axis, the marginal rate of substitution is equal to a. b. c.. ΔQ X ΔQY.MUX MUY PX PY. d. the ratio of the slope of the budget line and the slope of the indifference curve. e. 1 at the optimal level of consumption. Tackle the Test: Free-Response Questions 1. Each of the combinations of iPod song downloads and DVD rentals shown in the table below give Kathleen an equal level of utility. Quantity of songs 0 1 2 3 4 Quantity of DVDs 8 6 4 2 0 a. Graph Kathleen’s indifference curve. b. Economists believe that the individual indifference curves for ordinary goods exhibit what two properties? c. Does Kathleen’s indifference curve exhibit the two properties from part b? Explain. Answer (8 points) Quantity of songs Quantity of DVDs horizontal axis and the quantity of good Y is measured on the vertical axis, which of the following is true? The optimal consumption bundle is found where a. MUX MUY = PX PY. b. the slope of the indifference curve equals the slope of the budget line. c. the indifference
curve is tangent to the budget line. = d. MUX PX MUY PY e. all of the above are true.. 1 point: Axes labeled “Quantity of songs” and “Quantity of DVDs” 1 point: Correctly plotted indifference curve points 1 point: Negative slope 1 point: Convex shape 1 point: Negative slope—yes 1 point: As more DVDs are rented, there must be fewer song downloads to give Kathleen the same level of utility as before. This trade-off of more of one good for less of another gives the indifference curve a negative slope. 1 point: Convex shape—no 1 point: The indifference curve is a straight line with a constant slope, rather than being a convex line with a slope that decreases in absolute value from left to right. 2. Kathleen has $20 to spend on iPod song downloads and DVD rentals each week. The price of an iPod song download is $2 and the price of a DVD rental is $5. a. Graph Kathleen’s budget line. b. Suppose all of Kathleen’s indifference curves have the same shape and slope as the one in Question 1. How many song downloads and DVD rentals will Kathleen purchase to maximize her utility? Explain 801 S e c t i o n 14 Appendix Review Summary 1. Private information can cause inefficiency in the allocation of risk. One problem is adverse selection, the result of private information about the way things are. It creates the “lemons problem” in the used-car market because buyers will pay only a price that reflects the risk of purchasing a lemon (bad car), which encourages sellers of high-quality cars to drop out of the market. Adverse selection can be limited in several ways—through the screening of individuals, through signaling that people use to reveal their private information, and through the building of a reputation. 2. A related problem is moral hazard: individuals have private information about their actions, which distorts their incentives to exert effort or care when someone else bears the costs of that lack of effort or care. It limits the ability of markets to allocate risk efficiently. Insurance companies try to limit moral hazard by imposing deductibles, placing more risk on the insured. 3. Preferences can be represented by an indifference curve map, a series of indifference curves. Each curve shows all of the consumption bundles that yield a given level of total utility. Indifference curves have two general properties: they never cross and greater distance from the origin
indicates higher total utility levels. The indifference curves of ordinary goods have two additional properties: they slope downward and are convex in shape. 4. The marginal rate of substitution, or MRS, of some good R in place of some good M—the rate at which a consumer is willing to substitute more R for less M—is equal to MUR /MUM and is also equal to the negative of the slope of the indifference curve when R is on the horizontal axis and M is on the vertical axis. Convex indifference curves get flatter as you move to the right along the horizontal axis and steeper as you move upward along the vertical axis because of diminishing marginal utility: a consumer requires more and more units of R to substitute for a forgone unit of M as the amount of R consumed rises relative to the amount of M consumed. 5. Most goods are ordinary goods, goods for which a consumer requires additional units of some other good as compensation for giving up some of the good, and for which there is a diminishing marginal rate of substitution. 6. A consumer maximizes utility by moving to the highest indifference curve his or her budget constraint allows. Using the tangency condition, the consumer chooses the bundle at which the indifference curve just touches the budget line. At this point, the relative price of R in terms of M, PR /PM (which is equal to the negative of the slope of the budget line when R is on the horizontal axis and M is on the vertical axis) is equal to the marginal rate of substitution of R in place of M, MUR /MUM (which is equal to the negative of the slope of the indifference curve). This gives us the relative price rule: at the optimal consumption bundle, the relative price is equal to the marginal rate of substitution. Rearranging this equation also gives us the optimal consumption rule. Two consumers faced with the same prices and income, but with different preferences and so different indifference curve maps, will make different consumption choices. Key Terms Private information, p. 782 Adverse selection, p. 783 Screening, p. 783 Signaling, p. 784 Reputation, p. 784 Moral hazard, p. 785 Deductible, p. 785 Indifference curve, p. 789 Indifference curve map, p. 789 Marginal rate of substitution (MRS), p. 794 Diminishing marginal rate of substitution, p. 795 Ordinary goods, p. 795 Tangency condition, p
. 796 Relative price, p. 797 Relative price rule, p. 798 802 Problems 1. You are considering buying a second-hand Volkswagen. From reading car magazines, you know that half of all Volkswagens have problems of some kind (they are “lemons”) and the other half run just fine (they are “plums”). If you knew that you were getting a plum, you would be willing to pay $10,000 for it: this is how much a plum is worth to you. You would also be willing to buy a lemon, but only if its price was no more than $4,000: this is how much a lemon is worth to you. And someone who owns a plum would be willing to sell it at any price above $8,000. Someone who owns a lemon would be willing to sell it for any price above $2,000. a. For now, suppose that you can immediately tell whether the car that you are being offered is a lemon or a plum. Suppose someone offers you a plum. Will there be trade? Now suppose that the seller has private information about the car she is selling: the seller knows whether she has a lemon or a plum. But when the seller offers you a Volkswagen, you do not know whether it is a lemon or a plum. So this is a situation of adverse selection. b. Since you do not know whether you are being offered a plum or a lemon, you base your decision on the expected value to you of a Volkswagen, assuming you are just as likely to buy a lemon as a plum. Calculate this expected value. c. Suppose, from driving the car, the seller knows she has a plum. However, you don’t know whether this particular car is a lemon or a plum, so the most you are willing to pay is your expected value. Will there be trade? 2. You own a company that produces chairs, and you are thinking about hiring one more employee. Each chair produced gives you revenue of $10. There are two potential employees, Fred Ast and Sylvia Low. Fred is a fast worker who produces ten chairs per day, creating revenue for you of $100. Fred knows that he is fast and so will work for you only if you pay him more than $80 per day. Sylvia is a slow worker who produces only five chairs per day, creating revenue for you of $50. Sylvia knows that she is slow and so will work for you if
you pay her more than $40 per day. Although Sylvia knows she is slow and Fred knows he is fast, you do not know who is fast and who is slow. So this is a situation of adverse selection. a. Since you do not know which type of worker you will get, you think about what the expected value of your revenue will be if you hire one of the two. What is that expected value? b. Suppose you offered to pay a daily wage equal to the ex- pected revenue you calculated in part a. Whom would you be able to hire: Fred, or Sylvia, or both, or neither? c. If you knew whether a worker were fast or slow, which one would you prefer to hire and why? Can you devise a compensation scheme to guarantee that you employ only the type of worker you prefer? Appendix 3. For each of the following situations, draw a diagram contain- ing three of Isabella’s indifference curves. a. For Isabella, cars and tires are perfect complements, but in a ratio of 1:4; that is, for each car, Isabella wants exactly four tires. Be sure to label and number the axes of your diagram. Place tires on the horizontal axis and cars on the vertical axis. b. Isabella gets utility only from her caffeine intake. She can consume Valley Dew or cola, and Valley Dew contains twice as much caffeine as cola. Be sure to label and number the axes of your diagram. Place cola on the horizontal axis and Valley Dew on the vertical axis. c. Isabella gets utility from consuming two goods: leisure time and income. Both have diminishing marginal utility. Be sure to label the axes of your diagram. Place leisure on the horizontal axis and income on the vertical axis. d. Isabella can consume two goods: skis and bindings. For each ski she wants exactly one binding. Be sure to label and number the axes of your diagram. Place bindings on the horizontal axis and skis on the vertical axis. e. Isabella gets utility from consuming soda. But she gets no utility from consuming water: any more, or any less, water leaves her total utility level unchanged. Be sure to label the axes of your diagram. Place water on the horizontal axis and soda on the vertical axis. 4. Use the four properties of indifference curves for ordinary goods illustrated in Figure 80.4 to answer the following questions. a. Can you rank the following two bundles? If so, which prop- er
ty of indifference curves helps you rank them? Bundle A: 2 movie tickets and 3 cafeteria meals Bundle B: 4 movie tickets and 8 cafeteria meals b. Can you rank the following two bundles? If so, which prop- erty of indifference curves helps you rank them? Bundle A: 2 movie tickets and 3 cafeteria meals Bundle B: 4 movie tickets and 3 cafeteria meals c. Can you rank the following two bundles? If so, which prop- erty of indifference curves helps you rank them? Bundle A: 12 videos and 4 bags of chips Bundle B: 5 videos and 10 bags of chips d. Suppose you are indifferent between the following two bundles: Bundle A: 10 breakfasts and 4 dinners Bundle B: 4 breakfasts and 10 dinners Now compare bundle A and the following bundle: Bundle C: 7 breakfasts and 7 dinners Can you rank bundle A and bundle C? If so, which property of indifference curves helps you rank them? (Hint: It may help if you draw this, placing dinners on the horizontal axis and breakfasts on the vertical axis. And remember that breakfasts and dinners are ordinary goods 803 This page intentionally left blank >> Solutions to AP Review Questions This section offers suggested answers to the AP Review Questions that appear at the end of each module. Module 1 Check Your Understanding 1. Land, labor, capital, and entrepreneurship are the four categories of resources. Possible examples include fisheries (land), time spent working on a fishing boat (labor), fishing nets (capital), and the opening of a new seafood market (entrepreneurship). 2. a. time spent flipping burgers at a restaurant: labor b. a bulldozer: capital c. a river: land 3. a. Yes. The increased time spent commuting is a cost you will incur if you accept the new job. That additional time spent commuting—or equivalently, the benefit you would get from spending that time doing something else—is an opportunity cost of the new job. b. Yes. One of the benefits of the new job is that you will be making $50,000. But if you take the new job, you will have to give up your current job; that is, you have to give up your current salary of $45,000, so $45,000 is one of the opportunity costs of taking the new job. c. No. A more spacious office is an additional benefit of your new job and does not involve forgoing something else, so it is not an opportunity
cost. 4. a. This is a normative statement because it stipulates what should be done. In addition, it may have no “right” answer. That is, should people be prevented from all dangerous personal behavior if they enjoy that behavior—like skydiving? Your answer will depend on your point of view. b. This is a positive statement because it is a description of fact. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b b a Tackle the Test: Free-Response Question 2. In positive economics there is a “right” or “wrong” answer. In normative economics there is not necessarily a “right” or “wrong” answer. There is more disagreement in normative economics because there is no “right” or “wrong” answer. Economists disagree because of (1) differences in values and (2) disagreements about models and about which simplifications are appropriate. Module 2 Check Your Understanding 1. We talk about business cycles for the economy as a 2. whole because recessions and expansions are not confined to a few industries—they reflect downturns and upturns for the economy as a whole. The data clearly show that in the steep downturns, almost every sector of the economy reduces output and the number of people employed. Moreover, business cycles are an international phenomenon, sometimes moving in rough synchrony across countries. Recessions cause a great deal of pain across the entire society. They cause large numbers of workers to lose their jobs and make it difficult for workers to find new jobs. Recessions reduce the standard of living of many families and are usually associated with a rise in the number of people living below the poverty line, an increase in the number of people who may lose their houses because they can’t afford their mortgage payments, and a fall in the percentage of Americans with health insurance. Recessions also reduce the profits of firms. e a d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. Tackle the Test: Free-Response Question 2. b c Inflation is an overall increase in the price of goods and services throughout an economy. If inflation occurs, the price of donuts will most likely increase, but an increase in the price of this one good does not indicate inflation. For example, the price of donuts might have increased due to an increase in the price of sugar, while the prices of most other
goods in the economy have remained unchanged. Module 3 Check Your Understanding 1. a. False. An increase in the resources available to Tom for use in producing coconuts and fish changes his production possibilities curve by shifting it outward, because he S-1 S- can now produce more fish and coconuts than before. In the accompanying graph, the line labeled “Tom’s original PPC” represents Tom’s original production possibilities curve, and the line labeled “Tom’s new PPC” represents the new production possibilities curve that results from an increase in resources available to Tom. Tackle the Test: Free-Response Question 2. Quantity of shelter (or food) Quantity of coconuts Tom’s original PPC Tom’s new PPC Quantity of ﬁsh b. True. A technological change that allows Tom to catch more fish for any amount of coconuts gathered results in a change in his production possibilities curve. This is illustrated in the accompanying graph. The new production possibilities curve is represented by the line labeled “Tom’s new PPC,” and the original production possibilities curve is represented by the line labeled “Tom’s original PPC.” Since the maximum quantity of coconuts that Tom can gather is the same as before, the new production possibilities curve intersects the vertical axis at the same point as the old curve. But since the maximum possible quantity of fish is now greater than before, the new curve intersects the horizontal axis to the right of the old curve. Quantity of coconuts Tom’s original PPC Tom’s new PPC Quantity of ﬁsh c. False. Production efficiency is achieved at points along a production possibilities curve, but every point inside a PPC is inefficient because more of either good could be produced without producing less of the other. Points outside the PPC are simply unobtainable. c Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d d e a I (beyond the curve) U (under the curve) E (on the curve) PPC Quantity of food (or shelter) Module 4 Check Your Understanding 1. a. The United States has an absolute advantage in automobile production because it takes fewer Americans (6) to produce a car in one day than it takes Italians (8). The United States also has an absolute advantage in washing machine production because it takes fewer Americans (2) to
produce a washing machine in one day than it takes Italians (3). b. In Italy the opportunity cost of a washing machine in terms of an automobile is 3⁄8. In other words, 3⁄8 of a car can be produced with the same number of workers and in the same time it takes to produce 1 washing machine. In the United States the opportunity cost of a washing machine in terms of an automobile is 2⁄6 = 1⁄3. In other words, 1⁄3 of a car can be produced with the same number of workers and in the same time it takes to produce 1 washing machine. Since 1⁄3 < 3⁄8, the United States has a comparative advantage in the production of washing machines: to produce a washing machine, only 1⁄3 of a car must be given up in the United States but 3⁄8 of a car must be given up in Italy. This means that Italy has a comparative advantage in automobiles. This can be checked as follows. The opportunity cost of an automobile in terms of a washing machine in Italy is 8⁄3, equal to 22⁄3. In other words, 22⁄3 washing machines can be produced with the same number of workers and in the time it takes to produce 1 car in Italy. And the opportunity cost of an automobile in terms of a washing machine in the United States is 6⁄2, equal to 3. In other words, 3 washing machines can be produced with the same number of workers and in the time it takes to produce 1 car in the United States. c. The greatest gains are realized when each country specializes in producing the good for which it has a comparative advantage. Therefore, based on this example, the United States should specialize in washing machines and Italy should specialize in automobiles. 2. At a trade of 1 fish for 11⁄2 coconuts, Hank gives up less for a fish than he would if he were producing fish himself—that is, he gives up less than 2 coconuts for 1 fish. Likewise, Tom gives up less for a coconut than he would if he were producing coconuts himself—with trade, a coconut costs 11⁄2 = 2⁄3 of a fish, less than the 4⁄3 of a fish he must give up if he does not trade. a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d a a d Tackle the Test: Free-Response
Questions 2. a. Country A: opportunity cost of 1 bushel of wheat = 4 units of textiles Country B: opportunity cost of 1 bushel of wheat = 6 units of textiles b. Country A has an absolute advantage in the production of wheat (15 versus 10) c. Country A: opportunity cost of 1 unit of textiles = 1⁄4 bushel of wheat Country B: opportunity cost of 1 unit of textiles = 1⁄6 bushel of wheat Country B has the comparative advantage in textile production because it has a lower opportunity cost of producing textiles. (Alternate answer: Country B has the comparative advantage in the production of textiles because Country A has a comparative advantage in the production of wheat based on opportunity costs shown in part a.) Appendix Check Your Understanding 1. a. Panel (a) illustrates this relationship. The higher price of movies causes consumers to see fewer movies. The relationship is negative, and the slope is therefore negative. The price of movies is the independent variable, and the number of movies seen is the dependent variable. However, there is a convention in economics that, if price is a variable, it is measured on the vertical axis. So the quantity of movies is measured on the horizontal axis. b. Panel (c) illustrates this relationship. Since it is likely that firms would pay more to workers with more experience, then years of experience is the independent variable that would be shown on the horizontal axis, and the resulting income, the dependent variable, would be shown on the vertical axis. The slope is positive. c. Panel (d) illustrates this relationship. With the temperature on the horizontal axis as the independent variable, and the consumption of hot dogs on the vertical axis as the dependent variable, we see that there is no change in hot dog consumption regardless of the temperature. The slope is zero. d. Panel (c) illustrates this relationship. When the price of ice cream goes up, this causes consumers to choose a close alternative, frozen yogurt. The price of ice cream is the independent variable and the consumption of frozen yogurt is the dependent variable. However, there is a con-3 vention in economics that, if price is a variable, it is measured on the vertical axis. The quantity of frozen yogurt that consumers buy is on the horizontal axis. The slope is positive. e. Panel (d) illustrates this relationship. Because the intent is for diet books to influence the number of pounds lost, the number of diet books is the independent variable and belongs on
the horizontal axis. The number of pounds lost is the dependent variable measured on the vertical axis. The absence of a discernable relationship between the number of diet books purchased and the weight loss of the average dieter results in a horizontal curve. The slope is zero. f. Panel (b) illustrates this relationship. Although price is the independent variable and salt consumption the dependent variable, by convention the price appears on the vertical axis and the quantity of salt on the horizontal axis. Since salt consumption does not change regardless of the price, the curve is a vertical line, and the slope is infinity. 2. a. The income tax rate is the independent variable and is measured on the horizontal axis. Income tax revenue is the dependent variable and is measured on the vertical axis. Income tax revenue 0 80 100% Income tax rate (percent) b. If the income tax rate is 0% (there is no tax), tax revenue is zero. c. If the income tax rate is 100% (all of your income is taxed), you will have no income left after tax. Since people are unwilling to work if they receive no income after tax, no income will be earned. As a result, there is no income tax revenue. d. For tax rates less than 80%, tax rate and tax revenue are positively related, so the Laffer curve has a positive slope. For tax rates higher than 80%, the relationship between tax rate and tax revenue is negative, so the Laffer curve has a negative slope. Therefore, the Laffer curve looks like the accompanying graph with a maximum point at a tax rate of 80%. Module 5 Check Your Understanding 1. a. The quantity of umbrellas demanded is higher at any given price on a rainy day than on a dry day. This is a rightward shift of the demand curve, since at any given price the quantity demanded rises. This implies that any specific quantity can now be sold at a higher price. b. The quantity of weekend calls demanded rises in response to a price reduction. This is a movement along the demand curve for weekend calls. S-. The demand for roses increases the week of Valentine’s Day. This is a rightward shift of the demand curve. d. The quantity of gasoline demanded falls in response to a rise in price. This is a movement along the demand curve. e Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d a c a Tackle the Test: Free-Response Question 2. Price of apples D2
D1 Quantity of apples Module 6 Check Your Understanding 1. a. The quantity of houses supplied rises as a result of an increase in prices. This is a movement along the supply curve. b. The quantity of strawberries supplied is higher at any given price. This is an increase in supply, which shifts the supply curve to the right. c. The quantity of labor supplied is lower at any given wage. This is a decrease in supply, which shifts the supply curve leftward compared to the supply curve during school vacation. So, in order to attract workers, fast-food chains have to offer higher wages. d. The quantity of labor supplied rises in response to a rise in wages. This is a movement along the supply curve. e. The quantity of cabins supplied is higher at any given price. This is an increase in supply, which shifts the supply curve to the right. 2. a. This is an increase in supply, so the supply curve shifts rightward. At the original equilibrium price of the year before, the quantity of grapes supplied exceeds the quantity demanded, and the result is a surplus. The price of grapes will fall. b. This is a decrease in demand, so the demand curve shifts leftward. At the original equilibrium price, the quantity of hotel rooms supplied exceeds the quantity demanded. The result is a surplus. The rates for hotel rooms will fall. c. Demand increases, so the demand curve for second-hand snowblowers shifts rightward. At the original equilibrium price, the quantity of second-hand snowblowers demanded exceeds the quantity supplied. This is a case of shortage. The equilibrium price of second-hand snowblowers will rise. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b c d Tackle the Test: Free-Response Question 2. Price of oranges S2 P2 P1 E2 E1 S1 D Q2 Q1 Quantity of oranges Module 7 Check Your Understanding 1. a. The decrease in the price of gasoline caused a rightward shift in the demand for large cars. As a result of the shift, the equilibrium price of large cars rose and the equilibrium quantity of large cars bought and sold also rose. b. The technological innovation has caused a rightward shift in the supply of fresh paper made from recycled stock. As a result of this shift, the equilibrium price of fresh paper made from recycled stock has fallen and the equilibrium quantity bought and sold has risen. c. The fall in the price of
pay-per-view movies causes a leftward shift in the demand for movies at local movie theaters. As a result of this shift, the equilibrium price of movie tickets falls and the equilibrium number of people who go to the movies also falls. 2. Upon the announcement of the new chip, the demand curve for computers using the earlier chip shifts leftward (demand decreases), and the supply curve for these computers shifts rightward (supply increases). a. If demand decreases relatively more than supply increases, then the equilibrium quantity falls, as shown here-5 S1 S2 E1 Module 8 Check Your Understanding 1. Parking fee Price of computer P1 P2 E2 D1 D2 Q2 Q1 Quantity of computers b. If supply increases relatively more than demand decreases, then the equilibrium quantity rises, as shown here: Price of computer P1 P2 S1 E1 S2 E2 D1 D2 Q1 Q2 Quantity of computers In both cases, the equilibrium price falls. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b a a c Tackle the Test: Free-Response Question 2. Price of coffee (per cup) P1 P2 E1 E2 S2 S1 D Q1 Q2 Quantity (cups of coffee) $15 11 7 3 0 S E A B D 3,200 3,600 4,000 4,400 4,800 Quantity of parking spaces a. Fewer homeowners are willing to rent out their driveways because the price ceiling has reduced the payment they receive. This is an example of a fall in price leading to a fall in the quantity supplied. This is shown in the accompanying diagram by the movement from point E to point A along the supply curve, a reduction in quantity of 400 parking spaces. b. The quantity demanded increases by 400 spaces as the price decreases. At a lower price, more fans are willing to drive and rent a parking space. It is shown in the diagram by the movement from point E to point B along the demand curve. c. Under a price ceiling, the quantity demanded exceeds the quantity supplied; as a result, shortages arise. In this case, there will be a shortage of 800 parking spaces. It is shown by the horizontal distance between points A and B. d. Price ceilings result in wasted resources. The additional time fans spend to guarantee a parking space is wasted time. e. Price ceilings lead to the inefficient allocation of goods— here, the parking spaces—to
consumers. If less serious fans with connections end up with the parking spaces, diehard fans have no place to park. f. Price ceilings lead to black markets. 2. a. False. By lowering the price that producers receive, a price ceiling leads to a decrease in the quantity supplied. b. True. A price ceiling leads to a lower quantity supplied than in an efficient, unregulated market. As a result, some people who would have been willing to pay the market price, and so would have gotten the good in an unregulated market, are unable to obtain it when a price ceiling is imposed. c. True. Those producers who still sell the product now receive less for it and are therefore worse off. Other producers will no longer find it worthwhile to sell the product at all and so will also be made worse off. S-. Price of gas PF PE A S B Price ﬂoor E QF QE D Quantity of gas a. Some gas station owners will benefit from getting a higher price. QF indicates the sales made by these owners. But some will lose; there are those who make sales at the market equilibrium price of PE but do not make sales at the regulated price of PF. These missed sales are indicated on the graph by the fall in the quantity demanded along the demand curve, from point E to point A. b. Those who buy gas at the higher price of PF will probably receive better service; this is an example of inefficiently high quality caused by a price floor as gas station owners compete on quality rather than price. But opponents are correct to claim that consumers are generally worse off—those who buy at PF would have been happy to buy at PE, and many who were willing to buy at a price between PE and PF are now unwilling to buy. This is indicated on the graph by the fall in the quantity demanded along the demand curve, from point E to point A. c. Proponents are wrong because consumers and some gas station owners are hurt by the price floor, which creates “missed opportunities”—desirable transactions between consumers and station owners that never take place. The deadweight loss, the net gains forgone because of missed opportunities, is indicated by the shaded area in the accompanying figure. Moreover, the inefficiency of wasted resources arises as consumers spend time and money driving to other states. The price floor also tempts people to engage in black market activity. With the price floor, only QF units are sold. But at prices between PE and PF, there
are drivers who together want to buy more than QF and owners who are willing to sell to them, a situation likely to lead to illegal activity. e Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b b e c Tackle the Test: Free-Response Question 2. Price of housing (rent) S PE E Legal limit (rent control) Shortage D QS QE QD Quantity of housing Module 9 Check Your Understanding 1. a. The price of a ride is $7 since the quantity demanded at this price is 6 million: $7 is the demand price of 6 million rides. This is represented by point A in the accompanying figure. Fare (per ride) $7.00 5.00 3.00 Deadweight loss E A B S D 0 6 8 10 12 14 Quantity of rides (millions per year) b. At 6 million rides, the supply price is $3 per ride, represented by point B in the figure. The wedge between the demand price of $7 per ride and the supply price of $3 per ride is the quota rent per ride, $4. This is represented in the figure above by the vertical distance between points A and B. c. The quota discourages 4 million mutually beneficial transactions. The shaded triangle in the figure represents the deadweight loss. d. At 9 million rides, the demand price is $5.50 per ride, indicated by point C in the accompanying figure, and the supply price is $4.50 per ride, indicated by point D. The quota rent is the difference between the demand price and the supply price: $1. The deadweight loss is represented by the shaded triangle in the figure. As you can see, the deadweight loss is smaller when the quota is set at 9 million rides than when it is set at 6 million rides. Fare (per ride) $7.00 5.50 5.00 4.50 3.00 Deadweight loss C D E S D 0 6 8 9 10 12 14 Quantity of rides (millions per year) 2. The accompanying figure shows a decrease in demand by 4 million rides, represented by a leftward shift of the demand curve from D1 to D2: at any given price, the quantity demanded falls by 4 million rides. (For example, at a price of $5, the quantity demanded falls from 10 million to 6 million rides per year.) This eliminates the effect of a quota limit of 8 million rides. At
point E2, the new market equilibrium, the equilibrium quantity is equal to the quota limit; as a result, the quota has no effect on the market. Fare (per ride) $7.00 6.00 5.00 4.00 3.00 Quota E1 E2 S D1 0 6 8 10 12 14 Quantity of rides (millions per year) D2 d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5-7 Tackle the Test: Free-Response Question 2. Fare (per ride) S Demand price Supply price Quota rent E Quota D Quantity of rides Module 10 Check Your Understanding 1. Let’s start by considering the relationship between the total value added of all domestically produced final goods and services, and aggregate spending on domestically produced final goods and services. These two quantities are equal because every final good and service produced in the economy is either purchased by someone or added to inventories, and additions to inventories are counted as spending by firms. Next, consider the relationship between aggregate spending on domestically produced final goods and ser vices and total factor income. These two quantities are equal because all spending that is channeled to firms to pay for purchases of domestically produced final goods and ser vices is revenue for firms. Those revenues must be paid out by firms to their factors of production in the form of wages, profit, interest, and rent. Taken together, this means that all three methods of calculating GDP are equivalent. 2. 3. Firms make sales to other firms, households, the government, and the rest of the world. Households are linked to firms through the sale of factors of production to firms, through purchases from firms of final goods and services, and through lending funds to firms in the financial markets. Households are linked to the government through their payment of taxes, their receipt of transfers, and their lending of funds to the government to finance government borrowing via the financial markets. Finally, households are linked to the rest of the world through their purchases of imports and transactions with foreigners in financial markets. You would be counting the value of the steel twice—once as it was sold by American Steel to American Motors and once as part of the car sold by American Motors. Tackle the Test: Multiple-Choice Questions 1. 2. c e S-. 4. 5. a b a Tackle the Test: Free-Response Question 2. This diagram should resemble Figure 10.1 plus the top half (the Government section) of Figure 10.
2. The leakages in this scenario are taxes and private savings that feed into government borrowing and the injections are government purchases of goods and services and government transfers. Module 11 Check Your Understanding 1. a. In 2009 nominal GDP was (1,000,000 × $0.40) + (800,000 × $0.60) = $400,000 + $480,000 = $880,000. The total value of sales of french fries in 2010 was 900,000 × $0.50 = $450,000. The total value of sales of onion rings in 2010 was 840,000 × $0.51 = $428,400. Nominal GDP in 2010 was $450,000 + $428,400 = $878,400. To find real GDP in 2010, we must calculate the value of sales in 2010 using 2009 prices: (900,000 × $0.40) + (840,000 × $0.60) = $360,000 + $504,000 = $864,000. b. A comparison of nominal GDP in 2009 to nominal GDP in 2010 shows a decline of (($880,000 − $878,400) / $880,000) × 100 = 0.18%. But a comparison using real GDP shows a decline of (($880,000 − $864,000) / $880,000) × 100 = 1.8%. That is, a calculation based on real GDP shows a drop 10 times larger (1.8%) than a calculation based on nominal GDP (0.18%): in this case, the calculation based on nominal GDP underestimates the true magnitude of the change because it incorporates both quantity changes and price changes. A price index based on 1990 prices will contain a relatively low price of housing compared to a price index based on 2000 prices. This means that a 2000 price index used to calculate real GDP in 2010 will magnify the value of housing production in the economy and increase the relative size of the housing sector as a component of real GDP. 2. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b c c c Tackle the Test: Free-Response Question 2. a. Country A: (4,000–2,000/2,000) × 100 = 100% Country B: (6,000–2,000/2,000) × 100 = 200% b. Country A: It stayed the same. Country B: It
doubled. c. Country A: $4,000 (There was no price increase so it is the same.) Country B: $6,000/2 = $3,000 (Prices doubled.) d. Country A: (4,000–2,000/2,000) × 100 = 100% Country B: (3,000–2,000/2,000) × 100 = 50% e. Country A: 4,000/20 = $200 versus Country B: 3,000/15 = $200. It is the same. Module 12 Check Your Understanding 1. The advent of websites that enable job-seekers to find jobs more quickly will reduce the unemployment rate over time. However, websites that induce discouraged workers to begin actively looking for work again will lead to an increase in the unemployment rate over time. 2. a. Not counted as unemployed because not actively looking for work, but counted in broader measures of labor underutilization as a discouraged worker. b. Not counted as unemployed—considered employed because the teacher has a job. c. Unemployed: not working, actively looking for work. d. Not unemployed, but underemployed: working part-time for economic reasons. Counted in broader measures of labor underutilization. e. Not unemployed, but considered “marginally attached.” Counted in broader measures of labor underutilization. 3. Items (a) and (b) are consistent with the observed relationship between growth in GDP and changes in the unemployment rate. Item (c) is not. e Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b a b Tackle the Test: Free-Response Questions 2. a. Employed (underemployed); she is not working up to her full potential. b. Not in the labor force (discouraged). Once a worker stops actively seeking work, he or she falls out of the labor force. c. Employed (part-time); individuals are classified as employed if they work full or part time. d. Not in the labor force; he is not actively seeking employment. Module 13 Check Your Understanding 1. a. Frictional unemployment is unemployment due to the time workers spend searching for jobs. It is inevitable because workers may leave one job in search of another for a variety of reasons. Furthermore, there will always be new entrants into the labor force who are seeking a first job. During the search process,
these individuals will be counted as part of the frictionally unemployed. b. When the unemployment rate is low, frictional unemployment will account for a larger share of total unemployment because other sources of unemployment will be diminished. So the share of total unemployment composed of the frictionally unemployed will rise. 2. 2. A binding minimum wage represents a price floor below which wages cannot fall. As a result, actual wages cannot move toward equilibrium. So a minimum wage causes the quantity of labor supplied to exceed the quantity of labor demanded. Because this surplus of labor reflects unemployed workers, it affects the unemployment rate. Collective bargaining has a similar effect—unions are able to raise the wage above the equilibrium level. This will act like a minimum wage by causing the number of job seekers to be larger than the number of workers firms are willing to hire. Collective bargaining causes the unemployment rate to be higher than it otherwise would be, as shown in the accompanying figure. Wage rate WU WE Unemployed Labor supply E Unionnegotiated wage Labor demand QD QE QS Quantity of labor 3. An increase in unemployment benefits reduces the cost to individuals of being unemployed, causing them to spend more time searching for a new job. So the natural rate of unemployment would increase. a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b c e Tackle the Test: Free-Response Question 2. a. Frictional. Melanie is between jobs. b. Structural. Melanie is unemployed because wages are not at the market equilibrium. c. Cyclical. Melanie is unemployed due to an economic slowdown (recession). Module 14 Check Your Understanding 1. Shoe-leather costs as a result of inflation will be lower because it is now less costly for individuals to manage their assets in order to economize on their money hold-9 ings. ATM machines, for example, give customers 24-hour access to cash in thousands of locations. This reduction in the cost of obtaining money translates into lower shoe-leather costs. If inflation came to a complete stop for several years, the inflation rate of zero would be less than the expected in flation rate of 2–3%. Because the real interest rate is the nominal interest rate minus the inflation rate, the real interest rates on loans would be higher than expected, and lenders would gain at the expense of borrowers. Borrowers would have to repay their loans with funds that had a higher real value than had been expected. c e b Tackle the Test: Multiple
-Choice Questions 1. 2. 3. 4. 5. Tackle the Test: Free-Response Question 2. a. 0% d c b. You borrowed enough money to buy a couch and paid back just enough to buy the same couch (after inflation). Therefore, you gained the benefit of the loan without paying any real interest for it. c. Whoever gave you the loan lost. The loan was paid back after prices unexpectedly increased, so the lender received a real interest rate of 0% for letting you use the money for a year. Module 15 Check Your Understanding 1. Pre – frost, this market basket costs (100 × $0.20) + (50 × $0.60) + (200 × $0.25) = $20 + $30 + $50 = $100. The same market basket, post - frost, costs (100 × $0.40) + (50 × $1.00) + (200 × $0.45) = $40 + $50 + $90 = $180. So the price index is ($100/$100) × 100 = 100 before the frost and ($180/$100) × 100 = 180 after the frost, implying a rise in the price index of 80%. This increase in the price index is less than the 84.2% increase calculated in the text. The reason for this difference is that the new market basket of 100 oranges, 50 grapefruit, and 200 lemons contains proportionately more of an item that has experienced a relatively small price increase (the lemons, the price of which has increased by 80%) and proportionately fewer of an item that has experienced a relatively large price increase (the oranges, the price of which has increased by 100%). This shows that the price index can be very sensitive to the composition of the market basket. If the market basket contains a large proportion of goods whose prices have risen faster than the prices of other goods, it will lead to a higher estimate of the increase in the price level. If it contains a large proportion of goods whose prices have risen more slowly than the prices of other goods, it will lead to a lower estimate of the increase in the price level. S-10. a. A market basket determined 10 years ago will contain fewer cars than at present. Given that the average price of a car has grown faster than the average prices of other goods, this basket will underestimate the true increase in the price level because it contains relatively too few cars. b. A market basket determined
10 years ago will not contain broadband Internet access, so it cannot track the fall in prices of Internet access over the past few years. As a result, it will overestimate the true increase in the price level. 3. Using Equation 15-2, the inflation rate from 2006 to 2007 is (207.3 − 201.6)/201.6 × 100 = 2.8%. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b e c b Tackle the Test: Free-Response Question 2. GDP Deflator CPI 2004–05: (3.2/96.8) × 100 = 3.3% (6.4/188.9) × 100 = 3.4% 2005–06: (3.3/100.0) × 100 = 3.3% (6.3/195.3) × 100 = 3.2% Module 16 Check Your Understanding 1. A decline in investment spending, like a rise in investment spending, has a multiplier effect on real GDP—the only difference in this case is that real GDP falls instead of rises. The fall in I leads to an initial fall in real GDP, which leads to a fall in disposable income (because less production means a decrease in payments to workers), which leads to lower consumer spending, which leads to another fall in real GDP, and so on. So consumer spending falls as an indirect result of the fall in investment spending. 2. When MPC is 0.5, the multiplier is equal to 1/(1 − 0.5) = 1/0.5 = 2. When MPC is 0.8, the multiplier is equal to 1/(1 − 0.8) = 1/0.2 = 5. 3. If you expect your future disposable income to fall, you would like to save some of today’s disposable income to tide you over in the future. But you cannot do this if you cannot save. If you expect your future disposable income to rise, you would like to spend some of tomorrow’s higher income today. But you cannot do this if you cannot borrow. If you cannot save or borrow, your expected future disposable income will have no effect on your consumer spending today. In fact, your MPC must always equal 1: you must consume all your current disposable income today, and you will be unable to smooth your consumption over time. 4. a. An unexpected increase in consumer spending will result in a reduction in invent
ories as producers sell items from their inventories to satisfy this short -term increase in demand. This is negative unplanned inventory investment: it reduces the value of producers’ inventories. b. A rise in the cost of borrowing is equivalent to a rise in the interest rate: fewer investment spending projects are now profitable to producers, whether they are financed through borrowing or retained earnings. As a result, producers will reduce the amount of planned investment spending. c. A sharp increase in the rate of real GDP growth leads to a higher level of planned investment spending by producers as they increase production capacity to meet higher demand. d. As sales fall, producers sell less, and their inventories grow. This leads to positive unplanned inventory investment. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b c a Tackle the Test: Free-Response Question 2. 1. The interest rate is the price (or opportunity cost) of investing, thus they are negatively related. 2. Expected future real GDP—if a firm expects its sales to grow rapidly in the future, it will invest in expanded production capacity. 3. Production capacity—if a firm finds its existing production capacity insufficient for its future production needs, it will undertake investment spending to meet those needs. Module 17 Check Your Understanding 1. a. This is a shift of the aggregate demand curve. A decrease in the quantity of money raises the interest rate, since people now want to borrow more and lend less. A higher interest rate reduces investment and consumer spending at any given aggregate price level, so the aggregate demand curve shifts to the left. b. This is a movement up along the aggregate demand curve. As the aggregate price level rises, the real value of money holdings falls. This is the interest rate effect of a change in the aggregate price level: as the value of money falls, people want to hold more money. They do so by borrowing more and lending less. This leads to a rise in the interest rate and a reduction in consumer and investment spending. So it is a movement along the aggregate demand curve. c. This is a shift of the aggregate demand curve. Expectations of a poor job market, and so lower average disposable incomes, will reduce people’s consumer spending today at any given aggregate price level. So the aggregate demand curve shifts to the left. d. This is a shift of the aggregate demand curve. A fall in tax rates raises people’s disposable income. At any given aggregate price level
, consumer spending is now higher. So the aggregate demand curve shifts to the right. e. This is a movement down along the aggregate demand curve. As the aggregate price level falls, the real value of assets rises. This is the wealth effect of a change in the aggregate price level: as the value of assets rises, people will increase their consumption plans. This leads to higher consumer spending. So it is a movement along the aggregate demand curve. f. This is a shift of the aggregate demand curve. A rise in the real value of assets in the economy due to a surge in real estate values raises consumer spending at any given aggregate price level. So the aggregate demand curve shifts to the right. 2. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. a c c a Tackle the Test: Free-Response Question 2. The two effects that cause the aggregate demand curve to have a downward slope are the wealth effect and the interest rate effect of a change in the aggregate price level. The wealth effect: When the price level increases, the purchasing power of money decreases, causing consumers to scale back on spending. Because consumer spending is a component of aggregate demand, increases in the aggregate price level lead to decreases in the quantity of aggregate output demanded. The opposite is true for decreases in the price level. This negative relationship between the price level and the quantity of aggregate output demanded results in a downward-sloping aggregate demand curve. The interest rate effect: Increases in the aggregate price level cause people to want to hold more money, which increases the demand for money and drives interest rates up. Higher interest rates reduce investment spending because it costs more to borrow money. Thus, a rise in the price level leads to less investment spending, which is a component of aggregate demand, and causes the quantity of aggregate output demanded to decrease (and vice versa). The result is a downward-sloping aggregate demand curve. Module 18 Check Your Understanding 1. a. This represents a movement along the SRAS curve because the CPI—like the GDP deflator—is a measure of the aggregate price level, the overall price level of final goods and services in the economy. b. This represents a shift of the SRAS curve because oil is a commodity. The SRAS curve will shift to the right because production costs are now lower, leading to a higher quantity of aggregate output supplied at any given aggregate price level. c. This represents a shift of the SRAS curve because it involves a change in nominal wages. An
increase in legally mandated benefits to workers is equivalent to an -11 increase in nominal wages. As a result, the SRAS curve will shift leftward because production costs are now higher, leading to a lower quantity of aggregate output supplied at any given aggregate price level. You would need to know what happened to the aggregate price level. If the increase in the quantity of aggregate output supplied was due to a movement along the SRAS curve, the aggregate price level would have increased at the same time as the quantity of aggregate output supplied increased. If the increase in the quantity of aggregate output supplied was due to a rightward shift of the LRAS curve, the aggregate price level might not rise. Alternatively, you could make the determination by observing what happened to aggregate output in the long run. If it fell back to its initial level in the long run, then the temporary increase in aggregate output was due to a movement along the SRAS curve. If it stayed at the higher level in the long run, the increase in aggregate output was due to a rightward shift of the LRAS curve. e c a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. Tackle the Test: Free-Response Questions 2. a. The vertical axis should be labeled “Aggregate price level” d e (or “Price level”), the horizontal axis should be labeled “Real GDP” and the graph should show an upward sloping curve labeled “SRAS.” b. SRAS shifts to the left. Aggregate price level SRAS2 SRAS1 Real GDP c. an increase in commodity prices, an increase in nominal wages, and a decrease in productivity Module 19 Check Your Understanding 1. a. An increase in the minimum wage raises the nominal wage and, as a result, shifts the short - run aggregate supply curve to the left. As a result of this negative supply S-12. shock, the aggregate price level rises and aggregate output falls. b. Increased investment spending shifts the aggregate demand curve to the right. As a result of this positive demand shock, both the aggregate price level and aggregate output rise. c. An increase in taxes and a reduction in government spending both result in negative demand shocks, shifting the aggregate demand curve to the left. As a result, both the aggregate price level and aggregate output fall. d. This is a negative supply shock, shifting the short - run aggregate supply curve to the left. As a result, the aggregate price
level rises and aggregate output falls. As long - run growth increases potential output, the long run aggregate supply curve shifts to the right. If, in the short run, there is now a recessionary gap (aggregate output is less than potential output), nominal wages will fall, shifting the short - run aggregate supply curve to the right. This results in a fall in the aggregate price level and a rise in aggregate output. As prices fall, we move along the aggregate demand curve due to the wealth and interest rate effects of a change in the aggregate price level. Eventually, as long - run macroeconomic equilibrium is reestablished, aggregate output will rise to be equal to potential output, and the aggregate price level will fall to the level that equates the quantity of aggregate output demanded with potential output. c Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b a b Tackle the Test: Free-Response Question 2. LRAS Aggregate price level PE ELR SRAS Long-run macroeconomic equilibrium AD YP Real GDP Potential output b. This is an expansionary fiscal policy because it is an increase in government transfers that will increase disposable income. c. This is a contractionary fiscal policy because it is an increase in taxes, which will reduce disposable income. 2. Federal disaster relief that is quickly disbursed is more effective at stabilizing the economy than legislated aid because there is very little time lag between the time of the disaster and the time when relief is received by victims. In contrast, the process of creating new legislation is relatively slow, so legislated aid is likely to entail a time lag in its disbursement, potentially destabilizing the economy. 3. a. An economy is overstimulated when an inflationary gap is present. This will arise if an expansionary monetary or fiscal policy is implemented when the economy is currently in long - run macroeconomic equilibrium. This shifts the aggregate demand curve to the right, in the short run raising the aggregate price level and aggregate output and creating an inflationary gap. Eventually, nominal wages will rise and shift the short - run aggregate supply curve to the left, and aggregate output will fall back to potential output. This is the scenario envisaged by the speaker. b. No, this is not a valid argument. When the economy is not currently in long - run macroeconomic equilibrium, an expansionary monetary or fiscal policy does not lead to the outcome described above. Suppose a negative demand shock has shifted the aggregate demand curve to the
left, resulting in a recessionary gap. An expansionary monetary or fiscal policy can shift the aggregate demand curve back to its original position in long -run macroeconomic equilibrium. In this way, the short- run fall in aggregate output and deflation caused by the original negative demand shock can be avoided. So, if used in response to demand shocks, fiscal or monetary policy is an effective policy tool. e Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b b e a Tackle the Test: Free-Response Questions 2. a. Aggregate price level LRAS SRAS PE E Module 20 Check Your Understanding 1. a. This is a contractionary fiscal policy because it is a reduction in government purchases of goods and services. b. Expansionary AD YE YP Real GDP c. Decrease taxes, increase government purchases of goods and services, or increase government transfers Module 21 Check Your Understanding 1. A $500 million increase in government purchases of goods and services directly increases aggregate spending by $500 million, which then starts the multiplier in motion. It will increase real GDP by $500 million × 1/(1 − MPC). A $500 million increase in government transfers increases aggregate spending only to the extent that it leads to an increase in consumer spending. Consumer spending rises by MPC × $1 for every $1 increase in disposable income, where MPC is less than 1. So a $500 million increase in government transfers will cause a rise in real GDP only MPC times as much as a $500 million increase in government purchases of goods and services. It will increase real GDP by $500 million × MPC/(1 − MPC). 2. If government purchases of goods and services fall by $500 million, the initial fall in aggregate spending is $500 million. If there is a $500 million tax increase, the initial fall in aggregate spending is MPC × $500 million, which is less than $500 million because some of the tax payments are made with money that would otherwise have been saved rather than spent. 2. 3. Boldovia will experience greater variation in its real GDP than Moldovia because Moldovia has automatic stabilizers while Boldovia does not. In Moldovia the effects of slumps will be lessened by unemployment insurance benefits, which will support residents’ incomes, while the effects of booms will be diminished because tax revenues will go up. In contrast, incomes will not be supported in Boldovia during slumps because there
is no unemployment insurance. In addition, because Boldovia has lumpsum taxes, its booms will not be diminished by increases in tax revenue. Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b b c c e Tackle the Test: Free-Response Questions 2. a. $50 million multiplier = 1/(1 − MPC) = 1/(1 − 0.75) = 1/0.25 = 4 change in G × 4 = $200 million change in G = $50 million b. 10 $20 × multiplier = $200 million multiplier = 200/20 = 10 c. 0.1 1/(1 − MPC) = 1/MPS = 10 MPS = 0.-13 Module 22 Check Your Understanding 1. The transaction costs for (a) a bank deposit and (b) a share of a mutual fund are approximately equivalent because each can typically be accomplished by making a phone call, going online, or visiting a branch office. Transaction costs are highest for (c) a share of a family business since finding a buyer for the share consumes time and resources. The level of risk is lowest for (a) a bank deposit, since these deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000; somewhat higher for (b) a share of a mutual fund since despite diversification, there is still risk associated with holding stocks; and highest for (c) a share of a family business since this investment is not diversified. The level of liquidity is the lowest for (c) a share of a family business, since it can be sold only with the unanimous agreement of other members and it will take some time to find a buyer; higher for (b) a share of a mutual fund, since it will take only a few days between selling your shares and the payment being processed; and highest for (a) a bank deposit, since withdrawals can usually be made immediately. Economic development and growth are the result of, among other factors, investment spending on physical capital. Since investment spending is equal to savings, the greater the amount saved, the higher investment spending will be, and so the higher growth and economic development will be. So the existence of institutions that facilitate savings will help a country’s growth and economic development. As a result, a country with a financial system that provides low transaction costs, opportunities for diversification of risk, and high liquidity to its savers will experience faster growth and economic development
than a country that doesn’t. e a d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. Tackle the Test: Free-Response Questions 2. Mutual fund–a financial intermediary that creates a d b stock portfolio by buying and holding shares in companies and then selling shares of the stock portfolio to individual investors. Life insurance company–a firm that guarantees a payment to the policyholder’s beneficiaries (typically, the family) when the policyholder dies. Bank–an institution that helps resolve the conflict between lenders’ needs for liquidity and the illiquid financing needs of borrowers who don’t want to use the stock or bond markets. Pension fund–a nonprofit institution that collects the savings of its members and invests those funds in a variety of assets, providing its members with income when they retire. S-14 Module 23 Check Your Understanding 1. The defining characteristic of money is its liquidity: how easily it can be used to purchase goods and services. Although a gift certificate can easily be used to purchase a very defined set of goods or services (the goods or services available at the store issuing the gift certificate), it cannot be used to purchase any other goods or services. A gift certificate is therefore not money since it cannot easily be used to purchase all goods or services. 2. 3. Again, the important characteristic of money is its liquidity: how easily it can be used to purchase goods and services. M1, the narrowest definition of the money supply, consists only of currency in circulation, traveler’s checks, and checkable bank deposits. CDs aren’t checkable–and they can’t be made checkable without incurring a cost because there’s a penalty for early withdrawal. This makes them less liquid than the assets counted in M1. Commodity-backed money uses resources more efficiently than simple commodity money, like gold and silver coins, because commodity-backed money ties up fewer valuable resources. Although a bank must keep some of the commodity—generally gold and silver—on hand, it has to keep only enough to satisfy demand for redemptions. It can then lend out the remaining gold and silver, which allows society to use these resources for other purposes, with no loss in the ability to achieve gains from trade. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. a c e b Tackle the Test: Free-Response Questions 2. a. its official status given by
the U.S. government b. fiat money c. commodity money–money that has intrinsic value in other uses. Commodity-backed money–money that has no intrinsic value but can be converted into valuable goods on demand. Module 24 Check Your Understanding 1. a. The net present value of project A is unaffected by the interest rate since it is money received today; its present value is still $100. The net present value of project B is now −$10 + $115/1.02 = $102.75. The net present value of project C is now $119 − $20/1.02 = $99.39. Project B is now preferred. b. When the interest rate is lower, the cost of waiting for money that arrives in the future is lower. For example, at a 10% interest rate, $1 arriving one year from today is worth only $1/1.10 = $0.91. But when the interest rate is 2%, $1 arriving one year from today is worth $1/1.02 = $0.98, a sizable increase. As a result, project B, which has a benefit one year from today, becomes more attractive. And project C, which has a cost one year from today, becomes less attractive. e Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b c b Tackle the Test: Free-Response Questions 2. a. $1,000 × (1.05)3 = $1,000 × 1.16 = $1,157.63 b. $1,000/(1.05)3 = $863.84 Module 25 Check Your Understanding 1. Even though you know that the rumor about the bank is not true, you are concerned about other depositors pulling their money out of the bank. And you know that if enough other depositors pull their money out, the bank will fail. In that case, it is rational for you to pull your money out before the bank fails. All depositors will think like this, so even if they all know that the rumor is false, they may still rationally pull their money out, leading to a bank run. Deposit insurance leads depositors to worry less about the possibility of a bank run. Even if a bank fails, the FDIC will currently pay each depositor up to $250,000 per account. This will make you much less likely to pull your money out in response to a
rumor. Since other depositors will think the same, there will be no bank run. 2. 3. 4. The aspects of modern bank regulation that would frustrate this scheme are capital requirements and reserve requirements. Capital requirements mean that a bank has to have a certain amount of capital—the difference between its assets (loans plus reserves) and its liabilities (deposits). So the con artist could not open a bank without putting any of his own wealth in because his bank would need the required amount of capital—that is, it needs to hold more assets (loans plus reserves) than deposits. So the con artist would be at risk of losing his own wealth if his loans turn out badly. Since they have to hold only $100 in reserves, instead of $200, banks now lend out $100 of their reserves. Whoever borrows the $100 will deposit it in a bank (or spend it, and the recipient will deposit it in a bank), which will lend out $100 × (1 − rr) = $100 × 0.9 = $90. The borrowed $90 will likewise find its way into a bank, which will lend out $90 × 0.9 = $81, and so on. Overall, deposits will increase by $100/0.1 = $1,000. Silas puts $1,000 in the bank, of which the bank lends out $1,000 × (1 − rr) = $1,000 × 0.9 = $900. Whoever borrows the $900 will keep $450 in cash and deposit $450 in the bank. The bank will lend out $450 × 0.9 = $405. Whoever borrows the $405 will keep $202.50 in cash and deposit $202.50 in the bank. The bank will lend out $202.50 × 0.9 = $182.25, and so on. Overall this leads to an increase in deposits of $1,000 + $450 + $202.50 +... But it decreases the amount of currency in circulation: the amount of cash is reduced by the $1,000 Silas puts into the bank. This is offset, but not fully, by the amount of cash held by each borrower. The amount of currency in circulation therefore changes by −$1,000 + $450 + $202.50 +... The money supply therefore increases by the sum of the increase in deposits and the change in currency in circulation,
which is $1,000 − $1,000 + $450 + $450 + $202.50 + $202.50 +... and so on. Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d a e c d Tackle the Test: Free-Response Questions 2. a. The bank must hold $5,000 as required reserves (5% of $100,000). It is holding $10,000, so $5,000 must be excess reserves. b. The bank must hold an additional $50 as reserves because that is the reserve requirement multiplied by the deposit: 5% of $1,000. The bank can lend out $950. c. The money multiplier is 1/0.05 = 20. An increase of $2,000 in excess reserves can increase the money supply by $2,000 × 20 = $40,000. Module 26 Check Your Understanding 1. The Panic of 1907, the S&L crisis, and the crisis of 2008 all involved losses by financial institutions that were less regulated than banks. In the crises of 1907 and 2008, there was a widespread loss of confidence in the financial sector and collapse of credit markets. Like the crisis of 1907 and the S&L crisis, the crisis of 2008 exerted a powerful negative effect on the economy. 2. 3. The creation of the Federal Reserve failed to prevent bank runs because it did not eradicate the fears of depositors that a bank collapse would cause them to lose their money. The bank run eventually stopped after federal deposit insurance was instituted and the public came to understand that their deposits were protected. The balance sheet effect occurs when asset sales cause declines in asset prices, which then reduce the value of other firms’ net worth as the value of the assets on their balance sheets declines. In the vicious cycle of deleveraging, the balance sheet effect on firms forces their creditors to call in their loan contracts, forcing the firms to sell assets -15 to pay back their loans, leading to further asset sales and price declines. Because the vicious cycle of deleveraging occurs across different firms and no single firm can stop it, it is necessary for the government to step in to stop it. a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b a e Tackle the Test: Free-Response Questions 2. a. oversee the Federal Reserve System and serve on the Federal Open Market Committee b. 7 c. the president of the
United States d. 14-year terms e. to insulate appointees from political pressure f. 4 years; may be reappointed Module 27 Check Your Understanding 1. An open-market purchase of $100 million by the Fed increases banks’ reserves by $100 million as the Fed credits their accounts with additional reserves. In other words, this open-market purchase increases the monetary base (currency in circulation plus bank reserves) by $100 million. Banks lend out the additional $100 million. Whoever borrows the money puts it back into the banking system in the form of deposits. Of these deposits, banks lend out $100 million × (1 − rr) = $100 million × 0.9 = $90 million. Whoever borrows the money deposits it back into the banking system. And banks lend out $90 million × 0.9 = $81 million, and so on. As a result, bank deposits increased by $100 million + $90 million + $81 million +... = $100 million/rr = $100 million/0.1 = $1,000 million = $1 billion. Since in this simplified example all money lent out is deposited back into the banking system, there is no increase of currency in circulation, so the increase in bank deposits is equal to the increase in the money supply. In other words, the money supply increases by $1 billion. This is greater than the increase in the monetary base by a factor of 10: in this simplified model in which deposits are the only component of the money supply and in which banks hold no excess reserves, the money multiplier is 1/rr = 10. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b e c S-16 Tackle the Test: Free-Response Question 2. 1) provide financial services to depository institutions—regional Federal Reserve banks 2) supervise and regulate banking institutions—regional Federal Reserve banks and the Board of Governors 3) maintain the stability of the financial system—the Board of Governors 4) conduct monetary policy—the Federal Open Market Committee Module 28 Check Your Understanding 1. a. By increasing the opportunity cost of holding money, a high interest rate reduces the quantity of money demanded. This is a movement up and to the left along the money demand curve. b. A 10% fall in prices reduces the quantity of money demanded at any given interest rate, shifting the money demand curve leftward. c. This technological change reduces the quantity of money
demanded at any given interest rate, so it shifts the money demand curve leftward. d. Payments in cash require employers to hold more money, increasing the quantity of money demanded at any given interest rate. So it shifts the money demand curve rightward. 2. a. A 1% purchase fee on debit/credit card transactions for purchases less than $50 increases the benefit of holding cash because consumers will save money by paying with cash. b. An increase in the interest paid on six-month CDs raises the opportunity cost of holding cash because holding cash requires forgoing the higher interest paid. c. A fall in real estate prices has no effect on the opportunity cost or benefit of holding cash because real estate is an illiquid asset and therefore isn’t relevant in the decision of how much cash to hold. Also, real estate transactions are generally not carried out using cash. d. Because many purchases of food are made in cash, a significant increase in the cost of food increases the benefit of holding cash. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d d b e Tackle the Test: Free-Response Question 2. Interest rate, r MS E rE rL M ML MD Quantity of money At an interest rate below equilibrium, the quantity of money demanded exceeds the quantity of money supplied. People want to shift more of their wealth out of interestbearing assets such as CDs and hold it as money instead. Because the quantity of interest-bearing nonmoney assets demanded is less than the quantity supplied, those trying to sell these assets will have to offer a higher interest rate to attract buyers. As the interest rate rises, the quantity of money demanded decreases. This process continues until the market returns to equilibrium. Module 29 Check Your Understanding 1. a. As capital flows into the economy, the supply of loanable funds increases. This is illustrated by the shift of the supply curve from S1 to S2 in the accompanying diagram. As the equilibrium moves from E1 to E2, the equilibrium interest rate falls from r1 to r2, and the equilibrium quantity of loanable funds increases from Q1 to Q2. Interest rate, r r1 r2 S1 S2 E1 E2 D Q1 Q2 Quantity of loanable funds b. Savings fall due to the higher proportion of retired people, and the supply of loanable funds decreases. This is illustrated by the leftward shift of the supply curve from S1 to S2 in the accompanying diagram. The equilibrium
moves from E1 to E2, the equilibrium interest rate rises from r1 to r2, and the equilibrium quantity of loanable funds falls from Q1 to Q2. Interest rate, r r2 r1 S2 S1 E2 E1 D Q2 Q1 Quantity of loanable funds 2. We know from the loanable funds market that as the interest rate rises, households want to save more and consume less. But at the same time, an increase in the interest rate lowers the number of investment spending projects with returns at least as high as the interest rate. The statement “households will want to save more money than businesses will want to invest” cannot represent an equilibrium in the loanable funds market because it says that the quantity of loanable funds offered exceeds the quantity of loanable funds demanded. If that were to occur, the interest rate would fall to make the quantity of loanable funds offered equal to the quantity of loanable funds demanded. 3. a. The real interest rate will not change. According to the Fisher effect, an increase in expected inflation drives up the nominal interest rate, leaving the real interest rate unchanged. b. The nominal interest rate will rise by 3%. Each additional percentage point of expected inflation drives up the nominal interest rate by 1 percentage point. c. As long as inflation is expected, it does not affect the equilibrium quantity of loanable funds. Both the supply and demand curves for loanable funds are pushed upward, leaving the equilibrium quantity of loanable funds unchanged. c Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b b c a Tackle the Test: Free-Response Questions 2. a. This causes an increase (rightward shift) in the supply of loanable funds. b. This causes a decrease (leftward shift) in the demand for loanable funds. c. This causes an increase (rightward shift) in the demand for loanable funds. d. This causes a decrease (leftward shift) in the supply of loanable funds-17 Module 30 Check Your Understanding 1. The actual budget balance takes into account the effects of the business cycle on the budget deficit. During recessionary gaps, it incorporates the effect of lower tax revenues and higher transfers on the budget balance; during inflationary gaps, it incorporates the effect of higher tax revenues and reduced transfers. In contrast the cyclically adjusted budget balance factors out the effects of the business cycle and assumes that real GDP is at potential output. Since,
in the long run, real GDP tends to potential output, the cyclically adjusted budget balance is a better measure of the long-run sustainability of government policies. 2. In recessions, real GDP falls. This implies that consumers’ incomes, consumer spending, and producers’ profits also fall. So in recessions, states’ tax revenue (which depends in large part on consumers’ income, consumer spending, and producers’ profits) falls. In order to balance the state budget, states have to cut spending or raise taxes, but that deepens the recession. States without a balanced-budget requirement don’t have to take steps that would make things worse during a recession, and they can use expansionary fiscal policy to lessen the fall in real GDP. 3. a. A higher growth rate of real GDP implies that tax rev- enue will increase. If government spending remains constant and the government runs a budget surplus, the size of the public debt will be less than it would otherwise have been. b. If retirees live longer, the average age of the population increases. As a result, the implicit liabilities of the government increase because spending on programs for older Americans, such as Social Security and Medicare, will rise. c. A decrease in tax revenue without offsetting reductions in 4. government spending will cause the public debt to increase. d. Public debt will increase as a result of government bor- rowing to pay interest on its current public debt. In order to stimulate the economy in the short run, the government can use fiscal policy to increase real GDP. This entails borrowing, increasing the size of public debt further and leading to undesirable consequences: in extreme cases, governments can be forced to default on their debts. Even in less extreme cases, a large public debt is undesirable because government borrowing “crowds out” borrowing for private investment spending. This reduces the amount of investment spending, reducing the long-run growth of the economy. b Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d d c e S-18 Tackle the Test: Free-Response Question 2. Interest rate, r... leads to a rise in the equilibrium interest rate. r2 r1 E2 E1 S An increase in the demand for loanable funds... D2 D1 Quantity of loanable funds Persistent budget deficits increase the demand for loanable funds, thereby increasing interest rates and decreasing private investment. This is called “c
rowding out.” Module 31 Check Your Understanding 1. In the accompanying diagram, the increase in the demand for money is shown as a rightward shift of the money demand curve, from MD1 to MD2. This raises the equilibrium interest rate from r1 to r2. Interest rate, r r2 r1 MS E2 E1 M MD1 MD2 Quantity of money Interest rate, r MS1 MS2 r2 r1 E2 E1 E3 M1 M2 MD1 MD2 Quantity of money 3. a. The money supply curve shifts to the right. b. The equilibrium interest rate falls. c. Investment spending rises, due to the fall in the interest rate. d. Consumer spending rises, due to the multiplier process. e. Aggregate output rises because of the rightward shift of the aggregate demand curve. a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. a a c d Tackle the Test: Free-Response Questions 2. a. decrease the discount rate, decrease the reserve require- ment, open market purchases b. Interest rate, r An increase in the money supply... MS1 MS2 2. In order to prevent the interest rate from rising, the Federal Reserve must make an open-market purchase of Treasury bills, shifting the money supply curve rightward. This is shown in the accompanying diagram as the move from MS1 to MS2.... leads to a fall in the interest rate. r1 r2 E1 E2 M1 M2 MD Quantity of money c. No change in aggregate supply; aggregate demand increases. Lower interest rates lead to greater investment spending (and more interest-sensitive consumer spending). Aggregate demand is made up of C + I + G + (X − IM), so an increase in I and C increases AD. Interest rate changes don’t affect short-run aggregate supply. d. As shown in the accompanying figure, aggregate output increases in the short run. Aggregate price level An increase in the money supply reduces the interest rate and increases aggregate demand. LRAS SRAS1 E2 E1 AD2 AD1 Y1 Y2 Real GDP Module 32 Check Your Understanding 1. A 5% increase in the money supply will cause a 5% increase in the aggregate price level in the long run. The process begins in the short run, when the larger money supply decreases the interest rate and promotes investment spending. Investment spending is a component of aggregate demand, so
the increase in investment spending leads to an increase in aggregate demand, which causes real GDP to increase beyond potential output. The resulting upward pressure on nominal wages and other input prices shifts aggregate supply to the left until a new long-run equilibrium is reached. Although real GDP returns to its original level, both the increase in aggregate demand and the decrease in aggregate supply cause the aggregate price level to increase. The end result is 5% more money being spent on the same quantity of goods and services, which could only mean a 5% increase in the aggregate price level. 2. A 5% increase in the money supply will have no effect on the interest rate in the long run. As explained in the previous answer, a 5% increase in the money supply is matched by a 5% increase in the aggregate price level in the long run. Changes in the aggregate price level, in turn, cause proportional changes in the demand for money. So a 5% increase in the aggregate price level increases the quantity of money demanded at any given interest rate by 5%. This means that at the initial interest rate, the quantity of money demanded rises exactly as much as the money supply, and the new, long-run interest rate is therefore no different from the initial interest rate-19 c Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d c c e Tackle the Test: Free-Response Questions 2. a. Aggregate price level LRAS E3 SRAS2 SRAS1 E2 AD2 E1 AD1 YP Y1 Real GDP P3 P2 P1 Potential output b. The aggregate demand curve shifts to the right, creating a new equilibrium price level and real GDP. The higher money supply leads to a lower interest rate, which increases investment spending and consumer spending, and in turn aggregate demand. c. Wages rise over time, shifting short-run aggregate supply to the left. This brings equilibrium back to potential output with a higher price level. Module 33 Check Your Understanding 1. The inflation rate is more likely to quickly reflect changes in the money supply when the economy has had an extended period of high inflation. That’s because an extended period of high inflation sensitizes workers and firms to raise nominal wages and prices of intermediate goods when the aggregate price level rises. As a result, there will be little or no increase in real output in the short run after an increase in the money supply, and the increase in the money supply will simply be reflected in a proportional increase in prices.
In an economy where people are not sensitized to high inflation because of low inflation in the past, an increase in the money supply will lead to an increase in real output in the short run. This illustrates the fact that the classical model of the price level best applies to economies with persistently high inflation, not those with little or no history of high inflation even though they may currently have high inflation. S-20. Yes, there can still be an inflation tax because the tax is levied on people who hold money. As long as people hold money, regardless of whether prices are indexed or not, the government is able to use seignorage to capture real resources from the public. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b b c a Tackle the Test: Free-Response Question 2. Aggregate price level LRAS E2 P2 P1 AD2 AD1 E1 YP Real GDP Potential output Module 34 Check Your Understanding 1. When real GDP equals potential output, cyclical unem- ployment is zero and the unemployment rate is equal to the natural rate. This is the case at point E1 in the figure assuming a natural rate of 6%. Any unemployment in excess of this 6% rate represents cyclical unemployment. An increase in aggregate demand leads to a fall in the unemployment rate below the natural rate (negative cyclical unemployment) and an increase in the inflation rate. This is given by the movement from E1 to E2 in the figure and traces a movement upward along the short-run Phillips curve. A reduction in aggregate demand leads to a rise in the unemployment rate above the natural rate (positive cyclical unemployment) and a fall in the inflation rate. This would be repre sented by a movement down along the short-run Phillips curve from point E1. So for a given expected inflation rate, the short-run Phillips curve illustrates the relationship between cyclical unemployment and the actual inflation rate. Inflation rate 2% 0 E2 4 E1 6% SRPC Unemployment rate 2. 3. 4. There is no long-run trade-off between inflation and unemployment because after expectations of inflation change, wages will adjust to the change, returning employment and the unemployment rate to their equilibrium (natural) levels. This implies that once expectations of inflation fully adjust to any change in actual inflation, the unemployment rate will return to the natural rate of unemployment, or NAIRU. This also implies that the long-run Phillips curve is vertical. Dis
inflation is costly because to reduce the inflation rate, aggregate output in the short run must typically fall below potential output. This, in turn, results in an increase in the unemployment rate above the natural rate. In general, we would observe a reduction in real GDP. The costs of disinflation can be reduced by not allowing inflation to increase in the first place. The costs of any disinflation will also be lower if the central bank is credible and it announces in advance its policy to reduce inflation. In this situation, the adjustment to the disinflationary policy will be more rapid, resulting in a smaller loss of aggregate output. If the nominal interest rate is negative, an individual is better off simply holding cash, which has a 0% nominal rate of return. If the options facing an individual are to lend and receive a negative nominal interest rate or to hold cash and receive a 0% nominal rate of return, the individual will hold cash. Such a scenario creates the possibility of a liquidity trap, in which monetary policy is ineffective because the nominal interest rate cannot fall below zero. Once the nominal interest rate falls to zero, further increases in the money supply will lead firms and individuals to simply hold the additional cash. c b b Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. Tackle the Test: Free-Response Questions 2. a. 4% e e b. 2%, because 4% − 2% = 2% c. 0%, because although 4% − 6% = −2%, nominal interest rates can’t go below zero d. Lenders would effectively have to pay people to borrow money, in that what the lenders received back would be -21 less than what they lent out. No lending would take place. It is better to hold cash than to pay people to borrow money. e. Conventional monetary policy (decreasing interest rates) can’t happen if the nominal interest rate is already zero. This is called the zero bound OR a liquidity trap. Tackle the Test: Free-Response Questions 2. a. The aggregate supply curve is vertical so changes in the money supply affect only the aggregate price level. b. Changes in aggregate demand will affect aggregate out- Module 35 Check Your Understanding 1. A classical economist would have said that the aggressive monetary expansion would have had no short-run effect on aggregate output and would simply have resulted in a proportionate increase in the aggregate price level. 2. 3. Monetarists argue that central banks should
implement policy so that the money supply grows at some constant rate. Had the Fed pursued a monetarist policy during this period, we would have observed movements in M1 that would have shown a fixed rate of growth. We would not, therefore, have observed any of the reductions in M1 that are observed in the figure, nor would we have observed the acceleration in the rate of growth of M1 that occurred in 2001. As in Problem 2, a monetarist policy would have resulted in a constant rate of growth in M1. Between 1996 and 2000 the velocity of M1 rose steadily. After 2000 the velocity leveled off a bit and then rose again. Given a constant rate of money growth, these increases in the velocity of M1 would have been expansionary, causing increases in aggregate demand and the aggregate price level, other things equal. 4. The advocacy of fiscal policy (here in the form of tax cuts) to boost economic activity is Keynesian because Keynes promoted fiscal policy as a useful tool to dampen fluctuations in the business cycle. The praise of aggressive monetary policy is not Keynesian because Keynes worried that a liquidity trap would thwart the ability of monetary policy to change interest rates and influence investment spending. 5. a. Rational expectations theorists would argue that only unexpected changes in money supply would have any short-run effect on economic activity. They would also argue that expected changes in the money supply would affect only the aggregate price level, with no short-run effect of aggregate output. So such theorists would give credit to the Fed for limiting the severity of the 2001 recession only if the Fed’s monetary policy had been more aggressive than individuals expected during this period. b. Real business cycle theorists would argue that the Fed’s policy had no effect on ending the 2001 recession because they believe that fluctuations in aggregate output are caused largely by changes in total factor productivity. e Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b a d put. c. Business cycles are associated with fluctuations in the money supply. d. To avoid inflation, the unemployment rate must be set so that actual inflation equals expected inflation. e. Individuals and firms make optimal decisions using all available information. f. Fluctuations in total factor productivity growth cause the business cycle by causing the vertical aggregate supply curve to shift. Module 36 Check Your Understanding 1. The modern consensus has resolved the debate over the effectiveness of both expansionary fiscal and monetary policy. Expansionary fiscal policy is considered effective, although it is limited by
the problem of time lags, making monetary policy the stabilization tool of choice except in special circumstances. Expansionary monetary policy is considered effective except in the case of a liquidity trap. The modern consensus has not resolved, however, whether the Fed should adopt an inflation target, whether it should use monetary policy to manage asset price bubbles, and what, if any, kind of unconventional monetary policy it should use in the situation of a liquidity trap. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. a c e c Tackle the Test: Free-Response Question 2. Your answer can look like the diagram below, or it can have the axes reversed and a curve that resembles a mountain. Tax rate Tax revenue S-22 Module 37 Check Your Understanding 1. Economists want a measure of economic progress that rises with increases in the living standard of the average resident of a country. An increase in overall real GDP does not accurately reflect an increase in an average resident’s living standard because it does not account for growth in the number of residents. If, for example, real GDP rises by 10% but population grows by 20%, the living standard of the average resident falls: after the change, the average resident has only (110/120) × 100 = 91.6% as much real income as before the change. Similarly, an increase in nominal GDP per capita does not accurately reflect an increase in living standards because it does not account for any change in prices. For example, a 5% increase in nominal GDP per capita generated by a 5% increase in prices results in no change in living standards. Real GDP per capita is the only measure that accounts for both changes in the population and changes in prices. 2. 3. Using the Rule of 70, the amount of time it will take China to double its real GDP per capita is (70/8.8) = 8.0 years; India, (70/4.1) = 17.1 years; Ireland, (70/3.9) = 17.9 years; the United States, (70/1.9) = 36.8 years; France, (70/1.5) = 46.7 years; and Argentina (70/1.2) = 58.3 years. Since the Rule of 70 can be applied to only a positive growth rate, we cannot apply it to the case of Zimbabwe, which experienced negative growth. If India continues to have a higher growth rate of real GDP per capita
than the United States, then India’s real GDP per capita will eventually surpass that of the United States. The United States began growing rapidly over a century ago, but China and India have begun growing rapidly only recently. As a result, the living standard of the typical Chinese or Indian household has not yet caught up with that of the typical American household. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b c c b Tackle the Test: Free-Response Question 2. Increases in real GDP per capita result mostly from changes in productivity (or labor productivity). Productivity is defined as output per worker or output per hour. Increased labor force participation could also lead to higher real GDP per capita, but the rate of employment growth is rarely very different from the rate of population growth, meaning that the corresponding increase in output does not lead to an increase in output per capita. Module 38 Check Your Understanding 1. a. Significant technological progress will result in a positive growth rate of productivity even though physical capital per worker and human capital per worker are unchanged. b. Productivity will grow, but due to diminishing marginal returns, each successive increase in physical capital per worker results in a smaller increase in productivity than the one before it. 2. a. If the economy has grown 3% per year and the labor force has grown 1% per year, then productivity—output per worker—has grown at approximately 3% − 1% = 2% per year. b. If physical capital has grown 4% per year and the labor force has grown 1% per year, then physical capital per worker has grown at approximately 4% − 1% = 3% per year. c. According to estimates, each 1% rise in physical capital, other things equal, increases productivity by 0.3%. So, as physical capital per worker has increased by 3%, productivity growth that can be attributed to an increase in physical capital per worker is 0.3 × 3% = 0.9%. As a percentage of total productivity growth, this is 0.9%/2% × 100% = 45%. d. If the rest of productivity growth is due to technological progress, then technological progress has contributed 2% − 0.9% = 1.1% to productivity growth. As a percentage of total productivity growth, this is 1.1%/2% × 100% = 55%. 3. It will take time for workers to learn how to use the new computer system and to adjust their routines. And
because there are often setbacks in learning a new system, such as accidentally erasing your computer files, productivity at Multinomics may decrease for a period of time. e Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d a e b Tackle the Test: Free-Response Questions 2. a. Growing physical capital per worker is responsible for 1% productivity growth per year. 2% × 0.5 = 1% b. There was no growth in total factor productivity because there was no technological progress. According to the Rule of 70, over 70 years (from 1940 to 2010), a 1% growth rate would cause output to double. Real GDP per capita in this case doubled, as would be expected from a 1% productivity growth rate alone; therefore, there was no change in technological progress. Module 39 Check Your Understanding 1. A country that has high domestic savings is able to achieve a high rate of investment spending as a percent of GDP. This, in turn, allows the country to achieve a high growth rate. 2. 3. 4. As you can see from panel (b) of the figure on p. 382, although it is important in determining the growth rate for some countries (such as those of Western Europe), the initial level of GDP per capita isn’t the only factor. High rates of saving and investment appear to be better predictors of future growth than today’s standard of living. The evidence suggests that both sets of factors matter: better infrastructure is important for growth, but so is political and financial stability. Policies should try to address both areas. Growth increases a country’s greenhouse gas emissions. The current best estimates are that a large reduction in emissions will result in only a modest reduction in growth. The international burden sharing of greenhouse gas emissions reduction is contentious because rich countries are reluctant to pay the costs of reducing their emissions only to see newly emerging countries like China rapidly increase their emissions. Yet most of the current accumulation of gases is due to the past actions of rich countries. Poorer countries like China are equally reluctant to sacrifice their growth to pay for the past actions of rich countries. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. a c e b Tackle the Test: Free-Response Question 2. Physical capital, human capital, technology, and natural resources play roles in influencing long-run growth in real GDP per capita. Increases in both physical capital and human capital help a given labor force to produce
more over time. Although economic studies have suggested that increases in human capital may explain increases in productivity better than do increases in physical capital per worker, technological progress is probably the most important driver of productivity growth. Historically, natural resources played a prominent role in determining productivity, while today they play a less important role in increasing productivity than do increases in human or physical capital in most countries-23 Module 40 Check Your Understanding 1. Long-run economic growth is represented by an outward shift of the production possibilities curve. Short-run fluctuations are represented by a movement from a point below the production possibilities curve toward a point on the production possibilities curve (this shows an economic recovery/expansion) or by a movement to a point farther below the production possibilities curve (this shows a recession/contraction). 2. Long-run economic growth is represented by a rightward shift of the long-run aggregate supply curve. Short-run fluctuations are represented by movements of short-run equilibrium output (the level of real GDP at the intersection of short-run aggregate supply and aggregate demand) above or below potential output. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. a a c d Tackle The Test: Free-Response Questions 2. a. Aggregate price level P2 P1 b. Aggregate price level SRAS LRAS E2 E1 AD2 AD1 Y1 YP Real GDP Recessionary gap Potential output LRAS1 LRAS2 SRAS1 E1 E2 AD SRAS2 Real GDP S-24 Module 41 Check Your Understanding 1. a. The sale of the new airplane to China represents an export of a good to China and so enters the current account. b. The sale of Boeing stock to Chinese investors is a sale of a U.S. asset and so enters the financial account. c. Even though the plane already exists, when it is shipped to China it is an export of a good from the United States. So the sale of the plane enters the current account. d. Because the plane stays in the United States, the Chinese investor is buying a U.S. asset. So this is identical to the answer in part b: the sale of the jet enters the financial account. Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b a a e a Tackle the Test: Free-Response Questions 2. (a) United States Interest rate Equilibrium interest rate in the U.S. 4% International equilibrium interest rate
0 SUS EUS DUS Quantity of loanable funds Capital inﬂow to the United States Interest rate (b) China SC Equilibrium interest rate in China 4% 0 EC DC Quantity of loanable funds Capital outﬂow from China Module 42 Check Your Understanding 1. a. The increased purchase of Mexican oil would cause U.S. individuals (and firms) to increase their demand for the peso. To purchase pesos, individuals would increase their supply of U.S. dollars to the foreign exchange market, causing a rightward shift in the supply curve of U.S. dollars. This would cause the peso price of the dollar to fall (the amount of pesos per dollar would fall). The peso would appreciate and the U.S. dollar would depreciate as a result. b. With the appreciation of the peso it would take more U.S. dollars to obtain the same quantity of Mexican pesos. If we assume that the price level (measured in Mexican pesos) of other Mexican goods and services would not change, other Mexican goods and services would become more expensive to U.S. households and firms. The dollar cost of other Mexican goods and services would rise as the peso appreciated. So Mexican exports of goods and ser vices other than oil would fall. c. U.S. goods and services would become cheaper in terms of pesos, so Mexican imports of goods and services would rise. 2. a. The real exchange rate equals pesos per U.S. dollar × aggregate price level in the U.S./aggregate price level in Mexico. Today, the aggregate price level in both countries is 100. The real exchange rate today is: 10 × (100/100) = 10. The aggregate price level in five years in the U.S. will be 100 × (120/100) = 120, and in Mexico it will be 100 × (1,200/800) = 150. Thus, the real exchange rate in five years, assuming the nominal exchange rate does not change, will be 10 × (120/150) = 8. b. Today, a basket of goods and services that costs $100 costs 800 pesos, so the purchasing power parity is 8 pesos per U.S. dollar. In five years, a basket that costs $120 will cost 1,200 pesos, so the purchasing power parity will be 10 pesos per U.S. dollar. d Tackle the Test
: Multiple-Choice Questions 1. 2. 3. 4. 5. d d b b Tackle the Test: Free-Response Questions 2. In order to purchase more imports from Europe, U.S. consumers must supply more dollars in exchange for euros. As shown in the diagram, the increase in the supply of dollars shifts the dollar supply curve to the right and decreases the exchange rate from XR1 to XR2. Exchange rate (euros per U.S. dollar) XR1 XR2 Supply of U.S. dollars, S1 S2 E1 E2 D Quantity of U.S. dollars Module 43 Check Your Understanding 1. The accompanying diagram shows the supply of and demand for the yuan, with the U.S. dollar price of the yuan on the vertical axis. In 2005, prior to the revaluation, the exchange rate was pegged at 8.28 yuan per U.S. dollar or, equivalently, 0.121 U.S. dollars per yuan ($0.121). At the target exchange rate of $0.121, the quantity of yuan demanded exceeded the quantity of yuan supplied, creating the shortage depicted in the diagram. Without any intervention by the Chinese government, the U.S. dollar price of the yuan would be bid up, causing an appreciation of the yuan. The Chinese government, however, intervened to prevent this appreciation-25 Exchange rate (U.S. dollars per yuan) Equilibrium exchange rate XR* $0.121 Target exchange rate E S D 0 Quantity of yuan b. Placing restrictions on foreigners who want to invest in China would reduce the demand for the yuan, causing the demand curve to shift in the accompanying diagram from D1 to something like D2. This would cause a reduction in the shortage of the yuan. If demand fell to D3, the disequilibrium would be completely eliminated. Exchange rate (U.S. dollars per yuan) Target exchange rate $0.121 E1 E2 S D1D2D3 Exchange rate (U.S. dollars per yuan) Target exchange rate $0.121 S 0 Quantity of yuan E Shortage of yuan D c. Removing restrictions on Chinese who wish to invest abroad would cause an increase in the supply of the yuan and a rightward shift of the supply curve. This increase in supply would reduce the size of the shortage. If, for example, supply increased from S1 to S2, the disequilibrium would be eliminated completely, as
shown in the accompanying diagram. 0 Quantity of yuan a. If the exchange rate were allowed to float more freely, the U.S. dollar price of the exchange rate would move toward the equilibrium exchange rate (labeled XR* in the accompanying diagram). This would occur as a result of the shortage, when buyers of the yuan would bid up its U.S. dollar price. As the exchange rate increased, the quantity of yuan demanded would fall and the quantity of yuan supplied would increase. If the exchange rate were allowed to increase to XR*, the disequilibrium would be entirely eliminated. Exchange rate (U.S. dollars per yuan) Target exchange rate $0.121 E1 E2 S1 S2 D 0 Quantity of yuan S-26. Imposing a tax on exports (Chinese goods sold to for- eigners) would raise the price of these goods and decrease the amount of Chinese goods purchased. This would also decrease the demand for yuan with which to purchase those goods. The graphical analysis here is virtually identical to that found in the figure accompanying part b. 3. 4. 5. a d b e Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b a e a Tackle the Test: Free-Response Questions 2. a. Use foreign exchange reserves. To stabilize an exchange rate through exchange market intervention (e.g., buying its own currency), a country must keep large quantities of foreign currency on hand, which is usually a low-return investment. And large reserves can be quickly exhausted when there are large capital flows out of a country. b. Shifting supply and demand curves for currency through monetary policy. If a country chooses to stabilize an exchange rate by adjusting monetary policy rather than through intervention, it must divert monetary policy from other goals, notably stabilizing the economy and managing the inflation rate. c. Foreign exchange controls. These regulations distort incentives for importing and exporting goods and services. They can also create substantial costs in terms of red tape and corruption. Module 44 Check Your Understanding 1. The devaluations and revaluations most likely occurred in those periods when there was a sudden change in the franc-mark exchange rate: 1974, 1976, the early 1980s, 1986, and 1993–1994. 2. The high Canadian interest rates caused an increase in capital inflows to Canada. To obtain assets that yielded a relatively high interest rate in Canada, investors first had to obtain Canadian dollars. The increase in the demand for the Canadian dollar caused the
Canadian dollar to appreciate. This appreciation of the Canadian currency raised the price of Canadian goods to foreigners (measured in terms of the foreign currency). This made it more difficult for Canadian firms to compete in other markets. Tackle the Test: Multiple-Choice Questions 1. 2. c b Tackle the Test: Free-Response Questions 2. The decrease in aggregate demand that occurs during a recession includes the demand for goods and services produced abroad as well as at home. When a trading partner experiences a recession, it leads to a fall in their imports. The trading partner’s imports are the country’s exports. A reduction in foreign demand for the country’s domestic goods and services leads to a reduction in demand for the domestic currency. With a floating exchange rate, the currency depreciates. This makes domestic goods and services cheaper, so exports don’t fall by as much as they would have, and it makes imports more expensive, leading to a fall in imports. Both effects limit the decline in domestic aggregate demand. Module 45 Check Your Understanding 1. a. Aggregate price level LRAS SRAS P1 P2 Long-run macroeconomic equilibrium ELR E2 AD1 AD2 Y2 Y1 Real GDP Potential output b. Aggregate demand shifts left, real GDP and the aggregate price level fall. c. Nominal wages will decrease as a result of the recessionary gap and the decrease in the aggregate price level, leading to an increase in short-run aggregate supply. The rightward shift in the short-run aggregate supply curve moves the economy back to long-run equilibrium at potential output and a lower aggregate price level. d. Lower government spending will decrease the government budget deficit. With less borrowing by the government, the demand for loanable funds will decrease, shifting the demand curve from D1 to D2 and decreasing the interest rate from r1 to r2 in the accompanying figure. Interest rate r1 r2 S D1 D2 Quantity of loanable funds e Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b a e e Tackle the Test: Free-Response Questions Graph answers parts a and b. Aggregate price level P2 P1 LRAS E2 E1 SRAS AD2 AD1 Y1 Y2 Real GDP Potential output 2. a. The vertical axis is labeled “Aggregate price level” and the horizontal axis is labeled “Aggregate output” or “Real GDP.” The AD
curve slopes downward, the SRAS curve slopes upward, and the LRAS curve is vertical—all are labeled. The equilibrium aggregate price level and aggregate output are shown on the axes where the AD curve -27 and the SRAS curve intersect, which is to the left of the LRAS curve. b. The AD curve shifts to the right. The other curves are unchanged. The new equilibrium price level and aggregate output are shown on the axes at the new equilibrium point. The new equilibrium does not need to be at potential output. c. Axes are labeled “Interest rate” and “Quantity of loanable funds.” The demand curve slopes downward, the supply curve slopes upward, and the curves are labeled. The equilibrium interest rate and quantity are shown on the axes at the point where the curves intersect. The demand for loanable funds shifts to the right and the new equilibrium values are shown on the axes. The interest rate is higher. S Interest rate r2 r1 D2 D1 Q1 Q2 Quantity of loanable funds d. Axes are labeled “Exchange rate” and “Quantity of U.S. dollars.” The demand curve slopes downward, the supply curve slopes upward, and the curves are labeled. The equilibrium exchange rate and quantity are shown on the axes at the point where the two curves intersect. The supply of U.S dollars decreases, shifting the supply curve to the left, because the higher interest rate in the United States decreases the outflow of capital to countries with a relatively low interest rate. Exchange rate XR2 XR1 0 S2 S1 E2 E1 D Q1 Q2 Quantity of U.S. dollars e. The value of the U.S. dollar has increased (it has appreciated). U.S. exports will decline, and aggregate demand will decline. S-28 Module 46 Check Your Understanding 1. a. Since spending on orange juice is a small share of Clare’s spending, the income effect from a rise in the price of orange juice is insignificant. Only the substitution effect, represented by the substitution of lemonade for orange juice, is significant. b. Since rent is a large share of Delia’s expenditures, the increase in rent generates an income effect, making Delia feel poorer. Since housing is a normal good for Delia, the income and substitution effects move in the same direction, leading her to reduce her consumption of housing by moving to a smaller apartment. c.
Since a meal ticket is a significant share of the students’ living costs, an increase in its price will generate an income effect. Students respond to the price increase by eating more often in the cafeteria. So the substitution effect (which would induce them to eat in the cafeteria less often as they substitute restaurant meals in place of meals at the cafeteria) and the income effect (which would induce them to eat in the cafeteria more often because they are poorer) move in opposite directions. This happens because cafeteria meals are an inferior good. In fact, since the income effect outweighs the substitution effect (students eat in the cafeteria more as the price of meal tickets increases), cafeteria meals are a Giffen good. 2. 3. 4. By the midpoint method, the percent change in the price of strawberries is $1.00 − $1.50 ($1.50 + $1.00)/2 × 100 = −$0.50 $1.25 × 100 = −40% Similarly, the percent change in the quantity of strawberries demanded is 200,000 − 100,000 (100,000 + 200,000)/2 × 100 = 100,000 150,000 × 100 = 67% Dropping the minus sign, the price elasticity of demand using the midpoint method is 67%/40% = 1.7. By the midpoint method, the percent change in the quantity of movie tickets demanded in going from 4,000 tickets to 5,000 tickets is 5,000 − 4,000 (4,000 + 5,000)/2 × 100 = 1,000 4,500 × 100 = 22% Since the price elasticity of demand is 1 at the current consumption level, it will take a 22% reduction in the price of movie tickets to generate a 22% increase in quantity demanded. Since price rises, we know that quantity demanded must fall. Given the current price of $0.50, a $0.05 increase in price represents a 10% change, using the method in Equation 46-2. So the price elasticity of demand is % change in quantity demanded 10% = 1.2 so that the percent change in quantity demanded is 12%. A 12% decrease in quantity demanded represents 100,000 × 0.12, or 12,000 sandwiches. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b e c c Tackle the Test: Free-Response Questions 2. a. The substitution effect will
decrease the quantity demanded. As price increases, consumers will buy other goods instead. b. The income effect will increase the quantity demanded. As price increases, real income decreases, so consumers will purchase more of the inferior good. c. The substitution effect is larger than the income effect. If the income effect were larger than the substitution effect, more of the good would be purchased as the price increased, and the demand curve would be upward sloping. Module 47 Check Your Understanding 1. a. Elastic demand. Consumers are highly responsive to changes in price. For a rise in price, the quantity effect (which tends to reduce total revenue) outweighs the price effect (which tends to increase total revenue). Overall, this leads to a fall in total revenue. b. Unit-elastic demand. Here the revenue lost to the fall in price is exactly equal to the revenue gained from higher sales. The quantity effect exactly offsets the price effect. c. Inelastic demand. Consumers are relatively unresponsive to changes in price. For consumers to purchase a given percent more, the price must fall by an even greater percent. The price effect of a fall in price (which tends to reduce total revenue) outweighs the quantity effect (which tends to increase total revenue). As a result, total revenue decreases. d. Inelastic demand. Consumers are relatively unresponsive to price, so a given percent fall in output is accompanied by an even greater percent rise in price. The price effect of a rise in price (which tends to increase total revenue) outweighs the quantity effect (which tends to reduce total revenue). As a result, total revenue increases. 2. a. Once bitten by a venomous snake, the victim’s demand for an antidote is very likely to be perfectly inelastic because there is no substitute and it is necessary for survival. The demand curve will be vertical at a quantity equal to the needed dose. b. Students’ demand for blue pencils is likely to be perfectly elastic because there are readily available substitutes, such as yellow pencils. The demand curve will be horizontal at a price equal to that of non-blue pencils. Tackle the Test: Multiple-Choice Questions 1. 2-29 3. 4. 5. c b c Tackle the Test: Free-Response Questions 2. a. Price Elastic demand 4. 5. d c Tackle the Test: Free-Response Questions 2. a. 40%/20% = 2 b. elastic c. Price D Quantity b. An increase
in price will decrease total revenue because the negative quantity effect of the price increase is greater than the positive price effect of the price increase. Module 48 Check Your Understanding 1. By the midpoint method, the percent increase in Chelsea’s income is 2. 3. $18,000 − $12,000 ($12,000 + $18,000)/2 × 100 = $6,000 $15,000 × 100 = 40% Similarly, the percent increase in her consumption of CDs is 40 − 10 (10 + 40)/2 × 100 = 30 25 × 100 = 120% Chelsea’s income elasticity of demand for CDs is therefore 120%/40% = 3. The cross-price elasticity of demand is 5%/20% = 0.25. Since the cross-price elasticity of demand is positive, the two goods are substitutes. By the midpoint method, the percent change in the number of hours of web-design services contracted is 500,000 − 300,000 (300,000 + 500,000)/2 × 100 = 200,000 400,000 × 100 = 50% Similarly, the percent change in the price of web-design services is: $150 − $100 ($100 + $150)/2 × 100 = $50 $125 × 100 = 40% The price elasticity of supply is 50%/40% = 1.25. Hence supply is elastic. Tackle the Test: Multiple-Choice Questions 1. 2. 3. d b d S Quantity d. Inputs are readily available and can be shifted into/out of production at low cost. Module 49 Check Your Understanding 1. A consumer buys each pepper if the price is less than (or just equal to) the consumer’s willingness to pay for that pepper. The demand schedule is constructed by asking how many peppers will be demanded at any given price. The accompanying table illustrates the demand schedule. Price of pepper $0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 Quantity of peppers demanded Quantity of peppers demanded by Casey Quantity of peppers demanded by Josey When the price is $0.40, Casey’s consumer surplus from the first pepper is $0.50, from his second pepper $0.30, from his third pepper $0.10, and he does not buy any more peppers. Casey’s individual consumer surplus is therefore $0.90. Josey
’s consumer surplus from her first pepper is $0.40, from her second pepper $0.20, from her third pepper $0.00 (since the price is exactly equal to her willingness to pay, she buys the third pepper but receives no consumer surplus S-30. from it), and she does not buy any more peppers. Josey’s individual consumer surplus is therefore $0.60. Total consumer surplus at a price of $0.40 is therefore $0.90 + $0.60 = $1.50. A producer supplies each pepper if the price is greater than (or just equal to) the producer’s cost of producing that pepper. The supply schedule is constructed by asking how many peppers will be supplied at any price. The accompanying table illustrates the supply schedule. Price of pepper $0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 Quantity of peppers supplied Quantity of peppers supplied by Cara Quantity of peppers supplied by Jamie When the price is $0.70, Cara’s producer surplus from the first pepper is $0.60, from her second pepper $0.60, from her third pepper $0.30, from her fourth pepper $0.10, and she does not supply any more peppers. Cara’s individual producer surplus is therefore $1.60. Jamie’s producer surplus from his first pepper is $0.40, from his second pepper $0.20, from his third pepper $0.00 (since the price is exactly equal to his cost, he sells the third pepper but receives no producer surplus from it), and he does not supply any more peppers. Jamie’s individual producer surplus is therefore $0.60. Total producer surplus at a price of $0.70 is therefore $1.60 + $0.60 = $2.20. c Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b c c a Tackle the Test: Free-Response Questions 2. Price PE Consumer surplus Producer surplus E QE S D Quantity Module 50 Check Your Understanding 1. The quantity demanded equals the quantity supplied at a price of $0.50, the equilibrium price. At that price, a total quantity of five peppers will be bought and sold. Casey will buy three peppers and receive consumer surplus of $0.40 on his first, $0
.20 on his second, and $0.00 on his third pepper. Josey will buy two peppers and receive consumer surplus of $0.30 on her first and $0.10 on her second pepper. Total consumer surplus is therefore $1.00. Cara will supply three peppers and receive producer surplus of $0.40 on her first, $0.40 on her second, and $0.10 on her third pepper. Jamie will supply two peppers and receive producer surplus of $0.20 on his first and $0.00 on his second pepper. Total producer surplus is therefore $1.10. Total surplus in this market is therefore $1.00 + $1.10 = $2.10. 2. The following figure shows that, after the introduction of the excise tax, the price paid by consumers rises to $1.20; the price received by producers falls to $0.90. Consumers bear $0.20 of the $0.30 tax per pound of butter; producers bear $0.10 of the tax. The tax drives a wedge of $0.30 between the price paid by consumers and the price received by producers. As a result, the quantity of butter sold is now 9 million pounds-31 Price of butter (per pound) Price paid by consumers post-tax Price pre-tax Price received by producers post-tax $1.40 1.30 1.20 1.10 1.00 0.90 0.80 0.70 0.60 $0.20 of tax falls on consumers $0.10 of tax falls on producers S 3. 4. 5. b d c E D Tackle the Test: Free-Response Questions 2. Price 0 6 7 8 9 10 11 12 13 14 Quantity of butter (millions of pounds) 3. a. Without the excise tax, Zhang, Yves, Xavier, and Walter Excise tax sell, and Ana, Bernice, Chizuko, and Dagmar buy one can of soda each, at $0.40 per can. So the quantity bought and sold is 4. b. With the excise tax, Zhang and Yves sell, and Ana and Bernice buy one can of soda each. So the quantity sold is 2. c. Without the excise tax, Ana’s individual consumer sur- plus is $0.70 − $0.40 = $0.30, Bernice’s is $0.60 − $0.40 = $
0.20, Chizuko’s is $0.50 − $0.40 = $0.10, and Dagmar’s is $0.40 − $0.40 = $0.00. Total consumer surplus is $0.30 + $0.20 + $0.10 + $0.00 = $0.60. With the tax, Ana’s individual consumer surplus is $0.70 − $0.60 = $0.10 and Bernice’s is $0.60 − $0.60 = $0.00. Total consumer surplus post-tax is $0.10 + $0.00 = $0.10. So the total consumer surplus lost because of the tax is $0.60 − $0.10 = $0.50. d. Without the excise tax, Zhang’s individual producer surplus is $0.40 − $0.10 = $0.30, Yves’s is $0.40 − $0.20 = $0.20, Xavier’s is $0.40 − $0.30 = $0.10, and Walter’s is $0.40 − $0.40 = $0.00. Total producer surplus is $0.30 + $0.20 + $0.10 + $0.00 = $0.60. With the tax, Zhang’s individual producer surplus is $0.20 − $0.10 = $0.10 and Yves’s is $0.20 − $0.20 = $0.00. Total producer surplus post-tax is $0.10 + $0.00 = $0.10. So the total producer surplus lost because of the tax is $0.60 − $0.10 = $0.50. e. With the tax, two cans of soda are sold, so the government tax revenue from this excise tax is 2 × $0.40 = $0.80. f. Total surplus without the tax is $0.60 + $0.60 = $1.20. With the tax, total surplus is $0.10 + $0.10 = $0.20, and government tax revenue is $0.80. So deadweight loss from this excise tax is $1.20 − ($0.20 + $0.80) = $0.20. Tackle
the Test: Multiple-Choice Questions 1. 2. c e Tax revenue DWL E PC PE PP S D1 D2 QT QE Quantity Module 51 Check Your Understanding 1. Consuming a unit that generates negative marginal utility leaves the consumer with lower total utility than not consuming that unit at all. A rational consumer, a consumer who maximizes utility, would not do that. For example, Figure 51.1 shows that Cassie receives 64 utils if she consumes 8 clams, but if she consumes a 9th clam, she loses a util, decreasing her total utility to only 63 utils. Whenever consuming a unit generates negative marginal utility, the consumer is made better off by not consuming that unit, even when that unit is free. 2. a. The accompanying table shows the consumer’s consumption possibilities, bundles A through C. These consumption possibilities are plotted in the accompanying diagram, along with the consumer’s budget line. Consumption Bundle Quantity of popcorn (buckets) Quantity of movie tickets -32 Quantity of movie tickets A 2 1 0 B 2 BL C 4 Quantity of popcorn (buckets) Quantity of potatoes (pounds) 10 8 6 4 2 0 Bundle X is not affordable X BL 1 2 3 5 Quantity of clams (pounds) 4 b. The accompanying table shows the consumer’s consumption possibilities, A through D. These consumption possibilities are plotted in the accompanying diagram, along with the consumer’s budget line. Consumption Bundle Quantity of underwear (pairs) Quantity of socks (pairs Quantity of socks (pairs) 6 4 2 0 B C BL D 1 2 3 Quantity of underwear (pairs) 3. From Table 51.3 you can see that Sammy’s marginal utility per dollar from increasing his consumption of clams from 3 to 4 pounds and his marginal utility per dollar from increasing his consumption of potatoes from 9 to 10 pounds are the same, 0.75 utils. But a consumption bundle consisting of 4 pounds of clams and 10 pounds of potatoes is not Sammy’s optimal consumption bundle because it is not affordable given his income of $20; a bundle of 4 pounds of clams and 10 pounds of potatoes costs $4 × 4 + $2 × 10 = $36, $16 more than Sammy’s income. This can be illustrated with Sammy’s budget line from Figure 51.3: a bundle of 4 pounds of clams and 10 pounds of potatoes is represented by point X in the accompanying diagram
, a point that lies outside Sammy’s budget line. If you look at the horizontal axis of Figure 51.4, it is quite clear that there is no such thing in Sammy’s consumption possibilities as a bundle consisting of 4 pounds of clams and 10 pounds of potatoes. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b b a d Tackle the Test: Free-Response Questions 2. a. Quantity of good Y 5 0 20 Quantity of good X b. Yes, 100/$5 = 400/$20 c. Total utility will increase because marginal utility is positive, while marginal utility will decrease due to the principle of diminishing marginal utility. Module 52 Check Your Understanding 1. a. Supplies are an explicit cost because they require an out- lay of money. b. If the basement could be used in some other way that generates money, such as renting it to a student, then the implicit cost is that money forgone. Otherwise, the implicit cost is zero. c. Wages are an explicit cost. d. By using the van for their business, Karma and Don forgo the money they could have gained by selling it. So use of the van is an implicit cost. e. Karma’s forgone wages from her job are an implicit cost. 2. a. Economic profit is zero, as explained by the following cal- culations-33 Implicit cost = $2,000 + $23,000 = $25,000 Accounting profit = Total revenue − Explicit cost − Depreciation = $25,000 Economic profit = Total revenue − Explicit cost − Depreciation − Implicit cost = Accounting profit − Implicit cost = $25,000 − $25,000 = $0. b. An economic profit of zero is considered a “normal profit.” The resources devoted to this business could not earn more if used in the next best activity. This is just enough profit to keep you in this business with no regrets. e a d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. Tackle the Test: Free-Response Questions 2. a. Total revenue = 2,000 × $2 = $4,000 a c b. Accounting profit = $4,000 − $400 − $100 = $3,500 c. Sunny would need to know the opportunity cost of her c Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d
e c c Tackle the Test: Free-Response Questions 2. Price, cost of unit $5 0 MC MR = P Q* Quantity time. d. In general, she would calculate her economic profit and operate if she makes at least normal profit (meaning zero economic profit). In Sunny’s case, she earns $3,500 in accounting profit minus the $200 implicit cost of capital and the opportunity cost of her time. Because $3,500 − $200 = $3,300, she will make at least normal profit if the opportunity cost of her time is less than or equal to $3,300. Module 53 Check Your Understanding 1. The profit-maximizing level of output is three units because marginal cost goes from being below marginal revenue at a quantity of three to being above marginal revenue at a quantity of four, thus passing through marginal revenue at the third unit. 2. Price, cost of unit $21 17 15 13 10 8 MC MR = P Module 54 Check Your Understanding 1. a. The fixed input is the 10-ton machine and the variable input is electricity. b. As you can see from the declining numbers in the third column of the accompanying table, electricity does indeed exhibit diminishing returns: the marginal product of each additional kilowatt of electricity is less than that of the previous kilowatt. Quantity of electricity (kilowatts) Quantity of ice (pounds) Marginal product of electricity (pounds per kilowatt) 0 1 2 3 4 0 1,000 1,800 2,400 2,800 1,000 800 600 400 0 1 2 3 4 5 Quantity Proﬁt-maximizing quantity c. A 50% increase in the size of the fixed input means that Bernie now has a 15-ton machine, so the fixed input is now the 15-ton machine. Since it generates a 100% increase in output for any given amount S-34 of electricity, the quantity of output and the marginal product are now as shown in the accompanying table. Quantity of electricity (kilowatts) Quantity of ice (pounds) Marginal product of electricity (pounds per kilowatt) 2,000 1,600 1,200 800 TP 0 1 2 3 4 0 2,000 3,600 4,800 5,600 d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b a e a Tackle the Test: Free-Response Questions 2. Quantity of output 96 91 84 75 64
51 36 19 0 1 2 3 4 5 6 7 8 Quantity of labor Marginal product of labor 19 17 15 13 11 9 7 5 MPL 0 1 2 3 4 5 6 7 8 Quantity of labor Module 55 Check Your Understanding 1. a. As shown in the accompanying table, the marginal cost for each pie is found by multiplying the marginal cost of the previous pie by 1.5. The variable cost for each output level is found by summing the marginal cost for all the pies produced to reach that output level. So, for example, the variable cost of three pies is $1.00 + $1.50 + $2.25 = $4.75. Average fixed cost for Q pies is calculated as $9.00/Q since fixed cost is $9.00. Average variable cost for Q pies is equal to the variable cost for the Q pies divided by Q; for example, the average variable cost of five pies is $13.19/5, or approximately $2.64. Finally, average total cost can be calculated in two equivalent ways: as TC/Q or as AVC + AFC. Quantity of pies Marginal cost of pie 0 1 2 3 4 5 6 $1.00 1.50 2.25 3.38 5.06 7.59 Average fixed cost of pie Average variable cost of pie Average total cost of pie — — — $9.00 $1.00 $10.00 4.50 3.00 2.25 1.80 1.50 1.25 1.58 2.03 2.64 3.46 5.75 4.58 4.28 4.44 4.96 Variable cost $0.00 1.00 2.50 4.75 8.13 13.19 20.78 b. The spreading effect dominates the diminishing returns effect when average total cost is falling: the fall in AFC dominates the rise in AVC for pies 1 to 4. The diminishing returns effect dominates when average total cost is rising: the rise in AVC dominates the fall in AFC for pies 5 and 6. c. Alicia’s minimum-cost output is 4 pies; this generates the lowest average total cost, $4.28. When output is less than 4, the marginal cost of a pie is less than the average total cost of the pies already produced. So making an additional pie lowers average total cost. For example, the marginal cost of pie 3 is $2.25, whereas the average total cost of pies 1
and 2 is $5.75. So making pie 3 lowers average total cost to $4.58, equal to (2 × $5.75 + $2.25)/3. When output is more than 4, the marginal cost of a pie is greater than the average total cost of the pies already produced. Consequently, making an additional pie raises average total cost. So, although the marginal cost of pie 6 is $7.59, the average total cost of pies 1 through 5 is $4.44. Making pie 6 raises average total cost to $4.96, equal to (5 × $4.44 + $7.59)/6. Tackle the Test: Multiple-Choice Questions 1. 2. c e 3. 4. 5. e e a Tackle the Test: Free-Response Questions 2. Cost of unit MC ATC AVC AFC Quantity Module 56 Check Your Understanding 1. a. The accompanying table shows the average total cost of producing 12,000, 22,000, and 30,000 units for each of the three choices of fixed cost. For example, if the firm makes choice 1, the total cost of producing 12,000 units of output is $8,000 + 12,000 × $1.00 = $20,000. The average total cost of producing 12,000 units of output is therefore $20,000/12,000 = $1.67. The other average total costs are calculated similarly. 12,000 units 22,000 units 30,000 units $1.67 $1.36 $1.27 1.75 2.25 1.30 1.34 1.15 1.05 Average total cost from choice 1 Average total cost from choice 2 Average total cost from choice 3 So if the firm wanted to produce 12,000 units, it would make choice 1 because this gives it the lowest average total cost. If it wanted to produce 22,000 units, it would make choice 2. If it wanted to produce 30,000 units, it would make choice 3. b. Having historically produced 12,000 units, the firm would have adopted choice 1. When producing 12,000 units, the firm would have had an average total cost of $1.67. When output jumps to 22,000 units, the firm cannot alter its choice of fixed cost in the short run, so its average total cost in the short run will be $1.36. In the long run, however, it will adopt choice 2, making
its average total cost fall to $1.30-35 c. If the firm believes that the increase in demand is tempo- rary, it should not alter its fixed cost from choice 1 because choice 2 generates higher average total cost as soon as output falls back to its original quantity of 12,000 units: $1.75 versus $1.67. 2. a. This firm is likely to experience diseconomies of scale. As the firm takes on more projects, the costs of communication and coordination required to implement the expertise of the firm’s owner are likely to increase. b. This firm is likely to experience economies of scale. Because diamond mining requires a large initial setup cost for excavation equipment, long-run average total cost will fall as output increases. a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d e e e Tackle the Test: Free-Response Questions 2. Cost of unit ATC LRATC Economies of scale Diseconomies of scale Quantity Module 57 Check Your Understanding 1. a. oligopoly b. perfect competition c. monopolistic competition d. monopoly b Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d a a a S-36 Tackle the Test: Free-Response Questions 2. a. Price b. The profit-maximizing quantity is 4. c. The firm’s maximum profit is TR − TC = (4 × $14) − $56 = $56 − $56 = $0. $10 Demand Quantity b. $10 Module 58 Check Your Understanding 1. a. The firm maximizes profit at a quantity of 4, because it is at that quantity that MC = MR. b. At a quantity of 4 the firm just breaks even. This is because at a quantity of 4, P = ATC, so the amount the firm takes in for each unit—the price—exactly equals the average total cost per unit. 2. The lowest price that would allow the firm to break even is $10, for the minimum average total cost is $500/50 = $10, and price must at least equal minimum average total cost in order for the firm to break even. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d d c c Tackle the Test: Free-Response Questions 2. a MC 16 6 8 12 16 20 24 Module 59 Check Your Understanding 1. Price, cost of unit At
prices above P2, the ﬁrm operates with a proﬁt At prices above P1 and below P2, the ﬁrm operates in the short run with a loss At prices below P1, the ﬁrm shuts down immediately P2 P1 0 MC ATC AVC Q1 Q2 Quantity a. The firm should shut down immediately when price is less than minimum average variable cost, the shut-down price. In the accompanying diagram, this is optimal for prices in the range from 0 to P1. b. When the price is greater than the minimum average variable cost (the shut-down price) but less than the minimum average total cost (the break-even price), the firm should continue to operate in the short run even though it is making a loss. This is optimal for prices in the range from P1 to P2. c. When the price exceeds the minimum average total cost 2. (the break-even price), the firm makes a profit. This happens for prices in excess of P2. This is an example of a temporary shut-down by a firm when the market price lies below the shut-down price, the minimum average variable cost. The market price is the price of a lobster meal and the variable cost is the cost of the lobster, employee wages, and other expenses that increase as more meals are served. In this example, however, it is the average variable cost curve rather than the market price that shifts over time, due to seasonal changes in the cost of lobsters. Maine lobster shacks have relatively low average variable cost during the summer, when cheap Maine lobsters are available; during the rest of the year, their average variable cost is relatively high due to the high cost of imported lobsters. So the lobster shacks are open for business during the summer, when their minimum average variable cost lies below price; but they close during the rest of the year, when the price lies below their minimum average variable cost. Tackle the Test: Multiple-Choice Questions 1. 2. e d 3. 4. 5. b d c Tackle the Test: Free-Response Questions 2. a. 6 b. $20 × 6 = $120 c. $29.50 × 6 = $177 d. $120 − $177 = −$57 (or a loss of $57) e. No, because P < AVC Module 60 Check Your Understanding 1. a. A fall in the fixed cost of production generates
a fall in the average total cost of production and, in the short run, an increase in each firm’s profit at the current output level. So in the long run new firms will enter the industry. The increase in supply drives down price and profits. Once profits are driven back to zero, entry will cease. b. An increase in wages generates an increase in the average variable and the average total cost of production at every output level. In the short run, firms incur losses at the current output level, and so in the long run some firms will exit the industry. (If the average variable cost rises sufficiently, some firms may even shut down in the short run.) As firms exit, supply decreases, price rises, and losses are reduced. Exit will cease once losses return to zero. c. Price will rise as a result of the increased demand, leading to a short-run increase in profits at the current output level. In the long run, firms will enter the industry-37 2. generating an increase in supply, a fall in price, and a fall in profits. Once profits are driven back to zero, entry will cease. d. The shortage of a key input causes that input’s price to increase, resulting in an increase in average variable and average total cost for producers. Firms incur losses in the short run, and some firms will exit the industry in the long run. The fall in supply generates an increase in price and decreased losses. Exit will cease when the losses for remaining firms have returned to zero. In the accompanying diagram, point XMKT in panel (b), the intersection of S1 and D1, represents the long-run industry equilibrium before the change in consumer tastes. When tastes change, demand falls and the industry moves in the short run to point YMKT in panel (b), at the intersection of the new demand curve D2 and S1, the short-run supply curve representing the same number of egg producers as in the original equilibrium at point XMKT. As the market price falls, each individual firm reacts by producing less—as shown in panel (a)—as long as the market price remains above the minimum average variable cost. If market price falls below minimum average variable cost, the firm would shut down immediately. At point YMKT the price of eggs is below minimum average total cost, creating losses for producers. This leads some firms to exit, which shifts the short-run industry supply curve leftward to S2. A new long-run
equilibrium is established at point ZMKT. As this occurs, the market price rises again, and, as shown in panel (c), each remaining producer reacts by increasing output (here, from point Y to point Z). All remaining producers again make zero profits. The decrease in the quantity of eggs supplied in the industry comes entirely from the exit of some producers from the industry. The long-run industry supply curve is the curve labeled LRS in panel (b). Panel (a) Panel (b) Panel (c) Price, cost Price MC ATC X Y S2 ZMKT XMKT S1 LRS D1 YMKT D2 Price, cost MC ATC Z Y Quantity of eggs QZ QY QX Quantity of eggs Quantity of eggs Decrease in output from exit S-38 Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b a e b Tackle the Test: Free-Response Questions 2. Price of unit P1 P2 Market Firm S1 S2 D Price, cost of unit Proﬁt P1 P2 MC ATC MR1 = D1 MR2 = D2 Q1 Q2 Quantity q2 q1 Quantity Module 61 Check Your Understanding 1. a. The demand schedule is found by determining the price at which each quantity would be demanded. This price is the average revenue, found at each output level by dividing the total revenue by the number of emeralds produced. For example, the price when 3 emeralds are produced is $252/3 = $84. The price at the various output levels is then used to construct the demand schedule in the accompanying table. b. The marginal revenue schedule is found by calculating the change in total revenue as output increases by one unit. For example, the marginal revenue generated by increasing output from 2 to 3 emeralds is ($252 − $186) = $66. c. The quantity effect component of marginal revenue is the additional revenue generated by selling one more unit of the good at the market price. For example, as shown in the accompanying table, at 3 emeralds, the market price is $84; so, when going from 2 to 3 emeralds the quantity effect is equal to $84. d. The price effect component of marginal revenue is the decline in total revenue caused by the fall in price when one more unit is sold. For example, as shown in the table, when only 2 emeralds are sold, each emerald
sells at a price of $93. However, when Emerald, Inc. sells an additional emerald, the price must fall by $9 to $84. So the price effect component in going from 2 to 3 emeralds is (−$9) × 2 = −$18. That’s because 2 emeralds can only be sold at a price of $84 when 3 emeralds in total are sold, although they could have been sold at a price of $93 when only 2 in total were sold. Quantity effect component Price effect component Quantity of emeralds demanded 1 2 3 4 5 Price of emerald revenue Total Marginal revenue $100 $100 93 84 70 50 186 252 280 250 $86 66 28 −30 $93 84 70 50 −$7 −18 −42 −80 e. In order to determine Emerald, Inc.’s profit-maximizing output level, you must know its marginal cost at each output level. Its profit-maximizing output level is the one at which marginal revenue is equal to marginal cost. As the accompanying diagram shows, the marginal cost curve shifts upward to $400. The profit-maximizing price rises to $700 and quantity falls to 6. Profit falls from $3,200 to $300 × 6 = $1,800. The quantity a perfectly 2. competitive industry would produce decreases to 12, but profits remain unchanged at zero. Price, cost, marginal revenue of diamond $1,000 Proﬁt falls. MC shifts upward. 700 600 400 200 0 –200 –400 MC2 = ATC2 MC1 = ATC1 D 20 Quantity of diamonds 6 8 10 12 16 Proﬁt-maximizing quantity falls. MR QC b Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b c d Tackle the Test: Free-Response Questions 2. a. Price, cost, marginal revenue PM ATC MC MR QM D Quantity b. Yes, with the help of barriers to entry that keep competi- tors out. Module 62 Check Your Understanding 1. a. Cable Internet service is a natural monopoly. So the government should intervene if it believes that the current price exceeds average total cost, which includes the cost of laying the cable. In this case it should impose a price ceiling equal to average total cost. If the price does not exceed average total cost, the government should do nothing-39 b. The government should approve the
merger only if it fosters competition by transferring some of the company’s landing slots to another, competing airline. 2. a. False. Although some consumer surplus is indeed transformed into monopoly profit, this is not the source of inefficiency. As can be seen from Figure 62.1, panel (b), the inefficiency arises from the fact that some of the consumer surplus is transformed into deadweight loss (the yellow area), which is a complete loss not captured by consumers, producers, or anyone else. b. True. If a monopolist sold to all customers willing to pay an amount greater than or equal to marginal cost, all mutually beneficial transactions would occur and there would be no deadweight loss. 3. As shown in the accompanying diagram, a “smart” profit–maximizing monopolist produces QM, the output level at which MR = MC. A monopolist who mistakenly believes that P = MR produces the output level at which P = MC (when, in fact, P > MR, and at the true profitmaximizing level of output, P > MR = MC). This misguided monopolist will produce the output level QC, where the demand curve crosses the marginal cost curve—the same output level that would be produced if the industry were perfectly competitive. It will charge the price PC, which is equal to marginal cost, and make zero profit. The entire shaded area is equal to the consumer surplus, which is also equal to total surplus in this case (since the monopolist receives zero producer surplus). There is no deadweight loss because every consumer who is willing to pay as much as or more than marginal cost gets the good. A smart monopolist, however, will produce the output level QM and charge the price PM. Profit for the smart monopolist is represented by the green area, consumer surplus corresponds to the blue area, and total surplus is equal to the sum of the green and blue areas. The yellow area is the deadweight loss generated by the monopolist. Price, cost, marginal revenue PM PC MC = ATC D MR QM QC Quantity a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b a c b S-40 Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b e c a Tackle the Test: Free-Response Questions 2. Perfect Price Discrimination Price, cost Proﬁt with perfect price discrimination c D ATC MC Quantity Tackle the Test: Free
-Response Questions 2. Price, cost, marginal revenue b d f a e g h MR a. triangle bca b. triangle bed c. rectangle degf d. triangle ech Module 63 Check Your Understanding 1. a. False. The opposite is true. A price-discriminating monopolist will sell to some customers that would not find the product affordable if purchasing from a single-price monopolist—namely, customers with a high price elasticity of demand who are willing to pay only a relatively low price for the good. b. False. Although a price-discriminating monopolist does indeed capture more of the consumer surplus, less inefficiency is created: more mutually beneficial transactions occur because the monopolist makes more sales to customers with a low willingness to pay for the good. c. True. Under price discrimination consumers are charged prices that depend on their price elasticity of demand. A consumer with highly elastic demand will pay a lower price than a consumer with inelastic demand. 2. a. This is not a case of price discrimination because the product itself is different and all consumers, regardless of their price elasticities of demand, value the damaged merchandise less than undamaged merchandise. So the price must be lowered to sell the merchandise. b. This is a case of price discrimination. Senior citizens have a higher price elasticity of demand for restaurant meals (their demand for restaurant meals is more responsive to price changes) than other patrons. Restaurants lower the price to high-elasticity consumers (senior citizens). Consumers with low price elasticity of demand will pay the full price. c. This is a case of price discrimination. Consumers with a high price elasticity of demand will pay a lower price by collecting and using discount coupons. Consumers with a low price elasticity of demand will not use coupons. d. This is not a case of price discrimination; it is simply a case of supply and demand. MC = ATC D QM Quantity Consumer surplus is zero because each consumer is charged the maximum he or she is willing to pay. Module 64 Check Your Understanding 1. a. This will decrease the likelihood that the firm will collude to restrict output. By increasing output, the firm will generate a negative price effect. But because the firm’s current market share is small, the price effect will fall mostly on its rivals’ revenues rather than on its own. At the same time, the firm will benefit from a positive quantity effect. b. This will decrease the likelihood that
the firm will collude to restrict output. By acting noncooperatively and raising output, the firm will cause the price to fall. Because its rivals have higher costs, they will lose money at the lower price while the firm continues to make profits. So the firm may be able to drive its rivals out of business by increasing its output. c. This will increase the likelihood that the firm will collude. Because it is costly for consumers to switch products, the firm would have to lower its price substantially (with a commensurate increase in quantity) to induce consumers to switch to its product. So increasing output is likely to be unprofitable, given the large negative price effect. d. This will increase the likelihood that the firm will collude. It cannot increase sales because it is currently at maximum production capacity, making attempts to undercut rivals’ prices as under the Bertrand model fruitless due to the inability to produce the output needed to steal the rivals’ customers. This makes the option to cooperate in restricting output relatively attractive. a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d e e b Tackle the Test: Free-Response Questions 2. a. The first major reason is that cartels are illegal in the United States. The second major reason is that cartels set prices above marginal cost, which creates an incentive for each firm to cheat on the cartel agreement in order to make more profit. This incentive to cheat tends to cause cartels to fall apart. b. Under the Cournot model, each firm treats the production of other firms as fixed and chooses the quantity that will maximize profit. This type of quantity competition results in relatively low production levels and positive economic profit. Under the Bertrand model, firms undercut the prices of their rivals until price equals marginal cost. This type of price competition results in normal profit (zero economic profit), as under perfect competition. Module 65 Check Your Understanding 1. a. A Nash equilibrium is a set of actions from which neither side wants to deviate (change actions), given what the other is doing. Both sides building a missile is a Nash equilibrium because neither player wants to deviate from the decision to build a missile. To switch from building to not building a missile, given that the other player is building a missile, would result in a change from −10 to −20 utils. There is no other Nash equilibrium in this game because for any other set of actions, at least one side is not building a missile, and would be better
off switching to building a missile. b. Their total payoff is greatest when neither side builds a missile, in which case their total payoff is 0 + 0 = 0. c. This outcome would require cooperation because each side sees itself as better off by building a missile. If Margaret builds a missile but Nikita does not, Margaret gets a payoff of +8, rather than the 0 she gets if she doesn’t build a missile. Similarly, Nikita is better off if he builds a missile but Margaret doesn’t: he gets a payoff of +8, rather than the 0 he gets if he doesn’t build a missile. Indeed, both players have an incentive to build a missile regardless of what the other side does. So unless Nikita and Margaret are able to communicate in some way to enforce cooperation, they will act in their own individual interests and each will pursue its dominant strategy of building a missile. 2. a. Future entry by several new firms will increase competition and drive down industry profits. As a result, there is less future profit to protect by behaving cooperatively -41 today. This makes each oligopolist more likely to behave noncooperatively today. b. When it is very difficult for a firm to detect if another firm has raised output, it is very difficult to enforce cooperation by playing “tit for tat.” So it is more likely that a firm will behave noncooperatively. c. When firms have coexisted while maintaining high prices for a long time, each expects cooperation to continue. So the value of behaving cooperatively today is high, and it is likely that firms will engage in tacit collusion. c b b Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. Tackle the Test: Free-Response Questions 2. a c Firm B High P Low P A m r i F High P Low P high high high high low low low low Module 66 Check Your Understanding 1. a. This is evidence of tacit collusion. Firms in the industry are able to tacitly collude by setting their prices according to the published “suggested” price of the largest firm in the industry. This is a form of price leadership. b. This is not evidence of tacit collusion. Considerable varia- tion in market shares indicates that firms have been competing to capture each other’s business. c. This is not evidence of tacit collusion. These features make it less likely that consumers will
switch products in response to lower prices. So this is a way for firms to avoid any temptation to gain market share by lowering price. This is a form of product differentiation used to avoid direct competition. d. This is evidence of tacit collusion. In the guise of dis- cussing sales targets, firms can create a cartel by designating quantities to be produced by each firm. e. This is evidence of tacit collusion. By raising prices to-gether, each firm in the industry is refusing to undercut its rivals by leaving its price unchanged or lowering S-42 it. Because it could gain market share by doing so, refusing to do so supports the conclusion that there is tacit collusion. Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d d c e a Tackle the Test: Free-Response Questions 2. a. A large number of firms: having more firms means there is less incentive for any firm to behave cooperatively. b. Complex products/pricing schemes: keeping track of adherence to an agreement is more difficult. c. Differences in interests: firms often have different views of their own interests and of what a fair agreement would entail. d. Bargaining power of buyers: firms are less able to raise prices for buyers with significant bargaining power, which can result from size or access to many options. Module 67 Check Your Understanding 1. a. An increase in fixed cost shifts the average total cost curve upward. In the short run, firms incur losses because price is below average total cost. In the long run, some firms will exit the industry, resulting in a rightward shift of the demand curves for those firms that remain, since each firm now serves a larger share of the market. Long-run equilibrium is reestablished when the demand curve for each remaining firm has shifted rightward to the point where it is tangent to the firm’s new, higher average total cost curve. At this point each firm’s price just equals its average total cost, and each firm makes zero profit. b. A decrease in marginal cost shifts the average total cost curve and the marginal cost curve downward. In the short run, firms earn positive economic profit. In the long run new entrants are attracted into the industry by the profit. This results in a leftward shift of each existing firm’s demand curve because each firm now has a smaller share of the market. Long-run equilibrium is reestablished when each firm’s demand curve has shifted leftward to the
point where it is tangent to the new, lower average total cost curve. At this point each firm’s price just equals average total cost, and each firm makes zero profit. If all the existing firms in the industry joined together to create a monopoly, they could achieve positive economic profit in the short run. But this would induce new firms to create new, differentiated products and then enter the industry and capture some of the profit. So, in the long 2. run, thanks to the lack of barriers to entry, it would be impossible to maintain such a monopoly. 3. a. False. As illustrated in panel (b) of Figure 67.4, a monopolistically competitive firm sells its output at a price that exceeds marginal cost—unlike a perfectly competitive firm, which sells at a price equal to marginal cost. Not only does a monopolistically competitive firm maximize profit by charging more than marginal cost, but in longrun equilibrium, a price equal to marginal cost would be below average total cost and cause the firm to incur a loss. b. True. Firms in a monopolistically competitive industry could achieve higher profit (monopoly profit) if they all joined together as a single firm with a single product. Because each of the smaller firms possesses excess capacity, a single firm producing a larger quantity would have a lower average total cost. The effect on consumers, however, is ambiguous. They would experience less choice. But if consolidation substantially reduced industry-wide average total cost and increases industry-wide output, consumers could experience lower prices with the monopoly. c. True. Fads and fashions are promulgated by advertising and a desire for product differentiation, which are common in oligopolies and monopolistically competitive industries, but not in monopolies or perfectly competitive industries. Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b b b e e Tackle the Test: Free-Response Questions 2. Price, cost, marginal revenue MC ATC PMC = ATCMC MCMC MRMC QMC DMC Minimum-cost output Quantity Excess capacity Module 68 Check Your Understanding 1. a. This type of advertising is likely to be useful because it provides new information on an important product. b. This type of advertising is likely to be wasteful because it is focused on promoting Bayer aspirin over a rival’s aspirin despite the two products being medically indistinguishable. c. This is useful because the longevity of a business gives a potential customer information about its quality. 2. A successful brand
name indicates a desirable attribute, such as quality, to a potential buyer. So, other things equal—such as price—a firm with a successful brand name will achieve higher sales than a rival with a comparable product but without a successful brand name. This is likely to deter new firms from entering an industry in which an existing firm has a successful brand name. e Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d a e d Tackle the Test: Free-Response Questions 2. Product differentiation is efficient when it conveys useful information to consumers and the marginal benefit of the product differentiation exceeds the marginal cost. It is not efficient from a societal standpoint if it does not convey useful information or other benefits worth more than the resources devoted to it. This is likely to be the case, for example, if it misleads consumers or creates undesirable market power. Module 69 Check Your Understanding 1. Many college professors will depart for other lines of work if the government imposes a wage that is lower than the market wage. Fewer professors will result in fewer courses taught and therefore fewer college degrees produced. It will adversely affect sectors of the economy that depend directly on colleges, such as the local shopkeepers who sell goods and services to students and faculty, college textbook publishers, and so on. It will also adversely affect firms that use the “output” produced by colleges: new college graduates. Firms that need to hire new employees with college degrees will be hurt as a smaller supply results in a higher market wage for college graduates. Ultimately, the reduced supply of college-educated workers will result in a lower level of human capital in the entire economy relative to -43 what it would have been without the policy. And this will hurt all sectors of the economy that depend on human capital. The sectors of the economy that might benefit are firms that compete with colleges in the hiring of would-be college professors. For example, accounting firms will find it easier to hire people who would otherwise have been professors of accounting, and publishers will find it easier to hire people who would otherwise have been professors of English (easier in the sense that the firms can recruit would-be professors with a lower wage than before). In addition, workers who already have college degrees will benefit; they will command higher wages as the supply of collegeeducated workers falls. 2. a. The demand curve for labor shifts to the right. b. The demand curve for labor shifts to the left. b Tackle the Test: Multiple-Choice Questions
1. 2. 3. 4. 5. d b e a Tackle the Test: Free-Response Questions 2. a. Wage rate b. Wage rate Original Labor Demand New Labor Demand Quantity of labor New Labor Demand Original Labor Demand Quantity of labor S-44. Wage rate New Labor Demand Original Labor Demand Quantity of labor Module 70 Check your Understanding 1. a. This would increase the supply of land, shifting the supply curve to the right and leading to a new equilibrium at a lower rental rate and a higher quantity. b. This would increase the marginal product of land and thus the value of the marginal product of land. The VMP curve for land would shift to the right, leading to a new equilibrium at a higher rental rate and a higher quantity. 2. When firms from different industries compete for the same land, an inter-industry land market develops and, other things being equal, each unit of land used by the various industries will rent for the same equilibrium rental rate, R. According to the marginal productivity theory of income distribution, VMP for land = R for the last unit of land rented. Because each industry rents until VMP for land = R, the last unit of land rented in each of these different industries will have the same value of the marginal product of land. Module 71 Check Your Understanding 1. a. Clive is made worse off if, before the new law, he had preferred to work more than 35 hours per week. As a result of the law, he can no longer choose his preferred time allocation; he now consumes fewer goods and more leisure than he would like. b. Clive’s utility is unaffected by the law if, before the law, he had preferred to work 35 or fewer hours per week. The law has not changed his preferred time allocation. c. Clive can never be made better off by a law that restricts the number of hours he can work. He can only be made worse off (case a) or equally as well off (case b). 2. The substitution effect would induce Clive to work fewer hours and consume more leisure after his wage rate falls—the fall in the wage rate means the price of an hour of leisure falls, leading Clive to consume more leisure. But a fall in his wage rate also generates a fall in Clive’s income. The income effect of this is to induce Clive to consume less leisure and therefore work more hours, since he is now poorer and leisure is a normal good. If the income effect dominates the substitution effect, Clive
will in the end work more hours than before. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. a c e d c a a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. Tackle the Test: Free-Response Questions 2. e c Rental rate Tackle the Test: Free-Response Questions 2. Wage rate Market labor supply curve SLand W* W2 E1 E2 RLand Market labor demand curve = MRPL1 MRPL2 L2 L Quantity of labor (workers) DLand = VMPLand Q*Land Quantity of land Module 72 Check Your Understanding 1. Yes, the firm is employing the cost-minimizing combination of inputs because the marginal product per dollar is equal for capital and labor: 500/$100 = 1,000/$200 = 5 units of output per dollar. c Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b a c d Tackle the Test: Free-Response Questions 2. a. 20 b. 10/$10 = 1 pencil per dollar c. The firm would hire 6 workers. d. No. The marginal product per dollar spent on capital is 100/$50 = 2 pencils per dollar. Thus, the firm is not following the cost-minimization rule because the marginal product per dollar spent on labor (1) is less than the marginal product per dollar spent on capital (2). Module 73 Check Your Understanding 1. a. False. Income disparities associated with gender, race, and ethnicity can be explained by the marginal productivity theory of income distribution, provided that differences in marginal productivity across people are correlated with gender, race, or ethnicity. One possible source for such correlation is past discrimination. Such discrimination can lower individuals’ marginal productivity by, for example, preventing them from acquiring the human capital that would raise their productivity. Another possible source of the correlation is differences in work experience that are associated with gender, race, or ethnicity. For example, in jobs for which work experience or length of tenure is important, women may earn lower wages because on average more women than men take childcare-related absences from work. b. True. Companies that discriminate when their competitors do not are likely to hire less able workers because they discriminate against more able workers who are considered to be of the wrong gender, race, ethnicity, or other characteristic. And with less able workers, such companies are likely to earn less profit than their competitors who don
’t discriminate. c. Ambiguous. In general, workers who are paid less because they have less experience may or may not be the victims of discrimination. The answer depends on the reason for the lack of experience. If workers have less experience because they are young or have chosen to do something else rather than gain experience, then they are not victims of discrimination as long as the lower earnings are commensurate with the lower level of experience (as opposed, for example, to earning a lot less while having just a little less experience). But if workers lack experience because previous job discrimination prevented them from gaining experience, then they are indeed victims of discrimination when they are paid less-45 a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b a a e Tackle the Test: Free-Response Questions 2. a. Market power—firms with market power can organize to pay lower wages than would result in a perfectly competitive labor market. Monopsonies pay less than the value of the marginal product of labor. And unions can organize to demand higher wages than would result in a perfectly competitive labor market. b. Efficiency wages—some firms pay high wages to boost worker performance and encourage loyalty. c. Discrimination—some firms pay workers differently solely on the basis of worker characteristics that do not affect marginal productivity. Module 74 Check Your Understanding 1. a. This is an externality problem because the cost of waste water runoff is imposed on the farms’ neighbors with no compensation and no other way for the farms to internalize the cost. b. Since the large poultry farmers do not take the external cost of their actions into account when making decisions about how much waste water to generate, they will create more runoff than is socially optimal. They will produce runoff up to the point at which the marginal social benefit of an additional unit of runoff is zero; however, their neighbors experience a high, positive level of marginal social cost of runoff from this output level. So the quantity of wastewater runoff is inefficient: reducing runoff by one unit would reduce total social benefit by less than it would reduce total social cost. c. At the socially optimal quantity of waste water runoff, the marginal social benefit is equal to the marginal social cost. This quantity is lower than the quantity of wastewater runoff that would be created in the absence of government intervention or a private deal. Yasmin’s reasoning is not correct: allowing some late returns of books is likely to be socially optimal. Although you impose a marginal social cost on
others every day that you are late in returning a book, there is some positive marginal social benefit to you of returning a book late—you get a longer period during which to use it for education and pleasure. If you need it for a book report, the additional benefit from another day might be large indeed. The socially optimal number of days that a book is returned late is the number at which the marginal social benefit equals the marginal social cost. A fine so stiff that it prevents any late returns is likely to result in a situation in which people return books although the marginal social benefit of keeping them another day is greater than 2. S-46 the marginal social cost—an inefficient outcome. In that case, allowing an overdue patron another day would increase total social benefit more than it would increase total social cost. So charging a moderate fine that reduces the number of days that books are returned late to the socially optimal number of days is appropriate. a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b a d Tackle the Test: Free-Response Questions 2. a. The marginal social cost of pollution is the additional cost imposed on society by an additional unit of pollution. b. The marginal social benefit of pollution is the additional benefit to society from an additional unit of pollution. Even when a firm could provide the same quantity of output without polluting as much, there is a benefit from polluting more because the firm can devote less money and resources to pollution avoidance. c. The socially optimal level of pollution is that level at which the marginal social benefit of pollution equals the marginal social cost. Module 75 Check Your Understanding 1. This is a misguided argument. Allowing polluters to sell emissions permits makes polluters face a cost of polluting: the opportunity cost of not being able to sell the permits that cover that pollution. If a polluter chooses not to reduce its emissions, it cannot sell its emissions permits. As a result, it forgoes the opportunity of making money from the sale of the permits. So, despite the fact that the polluter receives a monetary benefit from selling the permits, the scheme has the desired effect: to make polluters internalize the externality of their actions and reduce the total amount of pollution. 2. a. Planting trees imposes an external benefit: the marginal social benefit of planting trees is higher than the marginal private benefit to individual tree planters because many people (not just those who plant the trees) can enjoy the improved air quality and lower summer temperatures
. The difference between the marginal social benefit and the marginal private benefit to individual tree planters is the marginal external benefit. A Pigouvian subsidy equal to the marginal external benefit could be placed on each tree planted in urban areas in order to increase the marginal private benefit to individual tree planters to the same level as the marginal social benefit. b. Water-saving toilets create an external benefit: the marginal private benefit to individual homeowners from replacing a traditional toilet with a water-saving toilet is almost zero because water is very inexpensive. But the marginal social benefit is large because fewer critical rivers and aquifers need to be pumped. The difference between the marginal social benefit and the marginal private benefit to individual homeowners is the marginal external benefit. A Pigouvian subsidy for installing watersaving toilets equal to the marginal external benefit could bring the marginal private benefit to individual homeowners in line with the marginal social benefit. c. Disposing of old computer monitors imposes an external cost: the marginal private cost to those disposing of old computer monitors is lower than the marginal social cost, since environmental pollution is borne by people other than the person disposing of the monitor. The difference between the marginal social cost and the marginal private cost to those disposing of old computer monitors is the marginal external cost. A Pigouvian tax on the disposal of computer monitors equal to the marginal external cost, or a system of tradable permits for their disposal, could raise the marginal private cost to those disposing of old computer monitors up to the level of the marginal social cost. a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d a c a Tackle the Test: Free-Response Questions 2. Negative Externality Price, marginal social cost PMSC POPT PMKT Pigouvian tax Marginal external cost O MSC S EMKT D QOPT QMKT Quantity of plastic water bottles Module 76 Check Your Understanding 1. a. A public space is generally nonexcludable, but it may or may not be rival in consumption, depending on the level of congestion. For example, if you and I are the only users of a jogging path in the public park, then your use will not prevent my use—the path is non rival in consumption. In this case the public space is a public good. But the space is rival in consumption if there are many people trying to use the jogging path at the same time or if my use of the public tennis court prevents your use of the same
court. In this case the public space becomes a common resource. b. A cheese burrito is both excludable and rival in consump- tion. Hence it is a private good. c. Information from a password-protected web site is excludable but non rival in consumption. So it is an artificially scarce good. d. Publicly announced information about the path of an incoming hurricane is nonexcludable and non rival in consumption, so it is a public good. 2. A private producer will supply only a good that is excludable; otherwise, the producer won’t be able to charge a price for it that covers the cost of production. So a private producer would be willing to supply a cheese burrito and information from a password-protected website but unwilling to supply a public park or publicly announced information about an incoming hurricane. a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. d b e e Tackle the Test: Free-Response Questions 2. a. Nonrival in consumption: the same unit of the good can be consumed by more than one person at the same time. Nonexcludable: suppliers of the good can’t prevent people who don’t pay from consuming the good. b. The additional cost is zero. Public goods are nonrival, so the same unit can be provided to additional community members at no added cost. Module 77 Check Your Understanding 1. a. This practice would be illegal because it constitutes a tying arrangement. b. This practice would be illegal because it constitutes exclu- sive dealing. c. This is legal because the merger does not lead to monopo- lization. d. This practice would be illegal because it is a collusive agreement to restrain trade. 2. Wind energy is created by a natural monopoly, which means that marginal cost is below average total cost in the relevant range of production. (If fact, the marginal cost of wind energy is virtually zero, because the wind itself is free.) Thus, a requirement to charge a price equal to marginal cost would result in a price below average total cost and cause the firm to incur a loss. Only with subsidies could the firm survive with marginal cost pricing. If policymakers chose average cost pricing instead, the operator of the wind farm would make a normal profit and no subsidy would be necessary-47 e Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b b c c Tackle the Test: Free-Response
Questions 2. Antitrust policy: prohibit practices that create monopolies and break up existing monopolies. Public ownership: have government operate the monopoly with the goal of efficiency rather than profit. Price regulation: restrict price to the lowest price that does not cause losses, which is the price at which the average total cost curve intersects the demand curve. Module 78 Check Your Understanding 1. The poverty threshold is an absolute measure of poverty. It defines individuals as poor if their incomes fall below a level that is considered adequate to purchase the necessities of life, irrespective of how well other people are doing. And that measure is fixed: in 2009, for instance, it took $10,956 for an individual living alone to purchase the necessities of life, regardless of how well-off other Americans were. In particular, the poverty threshold is not adjusted for an increase in living standards: even if other Americans are becoming increasingly well-off over time, in real terms (that is, in terms of how many goods an individual at the poverty threshold can buy) the poverty threshold remains the same. a Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b e c a Tackle the Test: Free-Response Questions 2. (Answers to the first part of the question will differ.) Economics can add to our knowledge of the facts regarding trade-offs involved in implementing government programs to redistribute income. However, economics can’t resolve differences in values and philosophies. Module 79 Check Your Understanding 1. The inefficiency caused by adverse selection is that an insurance policy with a premium based on the average risk of all drivers will attract only an adverse selection of S-48. bad drivers. Good (that is, safe) drivers will find this insurance premium too expensive and so will remain uninsured. This is inefficient. However, safe drivers are also those drivers who have had fewer moving violations for several years. Lowering premiums for only those drivers allows the insurance company to screen its customers and sell insurance to safe drivers, too. This means that at least some of the good drivers now are also insured, which decreases the inefficiency that arises from adverse selection. In a way, having no moving violations for several years is a way of building a reputation as a safe driver. The moral hazard problem in home construction arises from private information about what the contractor does: whether she takes care to reduce the cost of construction or allows costs to increase. The homeowner cannot, or can only imperfectly, observe the cost-reduction efforts of
the contractor. If the contractor were fully reimbursed for all costs incurred during construction, she would have no incentive to reduce costs. Making the contractor responsible for any additional costs above the original estimate means that she now has an incentive to keep costs low. However, this imposes risk on the contractor. For instance, if the weather is bad, home construction will take longer, and will be more costly, than if the weather had been good. Since the contractor pays for any additional costs (such as weather-induced delays) above the original estimate, she now faces risk that she cannot control. 3. a. True. Drivers with higher deductibles have more incentive to take care in their driving in order to avoid paying the deductible. This is a moral hazard phenomenon. b. True. Suppose you know that you are a safe driver. You have a choice of a policy with a high premium but a low deductible or one with a lower premium but a higher deductible. In this case, you would be more inclined to choose the cheap policy with the high deductible because you know that you will be unlikely to have to pay the deductible. When there is adverse selection, insurance companies use screening devices such as this to infer private information about how skillful people are as drivers. 2. d Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b a a b Tackle the Test: Free-Response Questions 2. This is an example of moral hazard. The government bears the cost of any lack of care in the individual/corporate decisions. Distorted incentives lead the individual/corporation to make riskier decisions because, if a decision is bad, the cost falls on others. The individuals/corporations must be given a personal stake in the result of their decisions. This could be achieved by making the individuals/corporations repay at least some portion of the bailout cost. Module 80 Check Your Understanding 1. a. As you can see from the accompanying diagram the four bundles are associated with three indifference curves: B on the 10-util indifference curve, A and C on the 6-util indifference curve, and D on the 4-util indifference curve. Quantity of licorice drops 7 6 5 4 3 2 1 0 6 utils I2 I3 I1 10 utils A B 4 utils C D 1 3 2 5 Quantity of chocolate kisses 4 b. From comparing the quantities of chocolate kisses and licorice drops, you can predict that Samantha will prefer B to A because B gives
her one more chocolate kiss and the same number of licorice drops as A. Next, you can predict that she will prefer C to D because C gives her one more chocolate kiss and the same number of licorice drops as D. You can also predict that she prefers B to D because B gives her two more licorice drops and the same number of chocolate kisses as D. But without data about utils, you cannot predict how Samantha would rank A versus C or D because C and D have more chocolate kisses but fewer licorice drops than A. Nor can you rank B versus C, for the same reason. Bundles A and B each generate 200 utils since they both lie on the 200-util indifference curve. Likewise, bundles A and C each generate 100 utils since they both lie on the 100-util indifference curve. But this implies that A generates 100 utils and also that A generates 200 utils. This is a contradiction and so cannot be true. Therefore, indifference curves cannot cross. 3. a. The marginal rate of substitution of books for games, MUB/MUG, is 2 for Lucinda and 5 for Kyle. This implies that Lucinda is willing to trade 1 more book for 2 fewer games and Kyle is willing to trade 1 more book for 5 fewer games. So starting from a bundle of 3 books and 6 games, Lucinda would be equally content with a bundle of 4 books and 4 games and Kyle would be equally content with a bundle of 4 books and 1 game. Lucinda finds it more difficult to trade games for books: she is willing to give up only 2 games for a book but Kyle is willing to give up 5 games for a book. If books are measured on the horizontal axis and games on the vertical axis, Kyle’s indifference curve will be steeper than Lucinda’s at the current consumption bundle. b. Lucinda’s current consumption bundle is optimal if PB/PG, the relative price of books in terms of games, is 2. Kyle’s current consumption bundle is not optimal at this relative price; his bundle would be optimal only if the relative price of books in terms of games were 5. Since, for -49 b. Kathleen would purchase 10 song downloads and 0 DVD rentals. We know that Kathleen wants to be on the highest indifference curve possible. We also know that there is no tangency point in this case because the indifference curve and the budget line are both straight lines with different slopes
. Thus, the highest indifference curve that touches the budget line will touch it on one of the axes. Since the slope of the budget line is steeper than the slope of the indifference curve (−2.5 versus −0.5), the highest indifference curve that can be afforded, given the budget line, is at the point 10 songs and 0 DVD rentals. = 2, he should consume Kyle, MUB/MUG fewer games and more books to lower his MUB/MUG until it is equal to 2. = 5, if PB/PG c Tackle the Test: Multiple-Choice Questions 1. 2. 3. 4. 5. b a e e Tackle the Test: Free-Response Questions 2. a. Quantity of songs 10 0 4 Quantity of DVD rentals This page intentionally left blank Glossary absolute advantage the advantage conferred by the ability to produce more of a good or service with a given amount of time and resources; not the same thing as comparative advantage. (p. 27) accounting profit a business’s revenue minus the explicit cost and depreciation. (p. 531) actual investment spending the sum of planned investment spending and unplanned inventory investment. (p. 169) AD–AS model the basic model used to understand fluctuations in aggregate output and the aggregate price level. It uses the aggregate demand curve and the aggregate supply curve together to analyze the behavior of the economy in response to shocks or government policy. (p. 190) administrative costs (of a tax) the resources used (which is a cost) by government to collect the tax, and by taxpayers to pay it, over and above the amount of the tax, as well as to evade it. (p. 508) adverse selection occurs when an individual knows more about the way things are than other people do. Adverse selection problems can lead to market problems: private information leads buyers to expect hidden problems in items offered for sale, leading to low prices and the best items being kept off the market. (p. 783) aggregate consumption function the relationship for the economy as a whole between aggregate current disposable income and aggregate consumer spending. (p. 164) aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world. (p. 172) aggregate output the economy’s total production of final goods and services for a given time period, usually a year. Real GDP is the numerical measure of aggregate output typically used by economists
. (pp. 12, 113) aggregate price level a measure of the overall level of prices in the economy. (p. 142) aggregate production function a hypothetical function that shows how productivity (real GDP per worker) depends on the quantities of physical Italicized terms within definitions are key terms that are defined elsewhere in this glossary. capital per worker and human capital per worker as well as the state of technology. (p. 376) aggregate spending the total spending on domestically produced final goods and services; the sum of consumer spending (C), investment spending (I), government purchases of goods and services (G), and exports minus imports (X − IM). (p. 106) aggregate supply curve a graphical representation that shows the relationship between the aggregate price level and the total quantity of aggregate output supplied. (p. 179) antitrust policy legislative and regulatory efforts undertaken by the government to prevent oligopolistic industries from becoming or behaving like monopolies. (p. 653) appreciation a rise in the value of one currency in terms of other currencies. (p. 422) artificially scarce good a good that is excludable but nonrival in consumption. (p. 751) automatic stabilizers government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands. Taxes that depend on disposable income are the most important example of automatic stabilizers. (p. 212) autonomous change in aggregate spending an initial rise or fall in aggregate spending that is the cause, not the result, of a series of income and spending changes. (p. 160) autonomous consumer spending the amount of money a household would spend if it had no disposable income. (p. 162) average cost pricing occurs when regulators set a monopoly’s price equal to its average cost to prevent the firm from incurring a loss. (p. 757) average fixed cost the fixed cost per unit of output. (p. 553) average total cost total cost divided by quantity of output produced. Also referred to as average cost. (p. 552) average variable cost the variable cost per unit of output. (p. 553) balance of payments accounts a summary of a country’s transactions with other countries, including two main elements: the balance of payments on the current account and the balance of payments on the financial account. (p. 410) balance of payments on the current account (current account) a country’s balance of payments on goods and services plus
net international transfer payments and factor income. (p. 412) balance of payments on the financial account (financial account) the difference between a country’s sales of assets to foreigners and its purchases of assets from foreigners during a given period. (p. 413) balance of payments on goods and services the difference between the value of exports and the value of imports during a given period. (p. 412) balance sheet effect the reduction in a firm’s net worth from falling asset prices. (p. 258) bank a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investments or investment spending needs of borrowers. (p. 229) bank deposit a claim on a bank that obliges the bank to give the depositor his or her cash when demanded. (p. 229) bank reserves currency held by banks in their vaults plus their deposits at the Federal Reserve. (p. 243) bank run a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure. (p. 246) barrier to entry something that prevents other firms from entering an industry. Crucial in protecting the profits of a monopolist. There are four types of barriers to entry: control over scarce resources or inputs, increasing returns to scale, technological superiority, and government-created barriers such as licenses. (p. 571) black market a market in which goods or services are bought and sold illegally, either because it is illegal to sell them at all or because the prices charged are legally prohibited by a price ceiling. (p. 81) bond loan in the form of an IOU that pays interest. (p. 104) G-1 G-2 G L O S S A R Y brand name a name owned by a particular firm that distinguishes its products from those of other firms. (p. 672) break-even price the market price at which a firm earns zero profits. (p. 592) budget balance the difference between tax revenue and government spending. A positive budget balance is referred to as a budget surplus; a negative budget balance is referred to as a budget deficit. (p. 223) budget constraint the cost of a consumer’s consumption bundle cannot exceed the consumer’s income. (p. 514) budget deficit the difference between tax revenue and government spending when government spending exceeds tax revenue. (p. 223) budget line all the consumption bundles available to a
consumer who spends all of his or her income. (p. 514) budget surplus the difference between tax revenue and government spending when tax revenue exceeds government spending. (p. 223) business cycle the short-run alternation between economic downturns, known as recessions, and economic upturns, known as expansions. (p. 10) capital manufactured goods used to make other goods and services. (p. 3) capital inflow the net inflow of funds into a country; the difference between the total inflow of foreign funds to the home country and the total outflow of domestic funds to other countries. A positive net capital inflow represents funds borrowed from foreigners to finance domestic investment; a negative net capital inflow represents funds lent to foreigners to finance foreign investment. (p. 223) cartel an agreement among several producers to obey output restrictions in order to increase their joint profits. (p. 639) central bank an institution that oversees and regulates the banking system and controls the monetary base. (p. 253) chain-linking the method of calculating changes in real GDP using the average between the growth rate calculated using an early base year and the growth rate calculated using a late base year. (p. 115) change in demand a shift of the demand curve, which changes the quantity demanded at any given price. (p. 51) change in supply a shift of the supply curve, which changes the quantity supplied at any given price. (p. 60) checkable bank deposits bank accounts on which people can write checks. (p. 231) classical model of the price level a model of the price level in which the real quantity of money is always at its long-run equilibrium level. This model ignores the distinction between the short run and the long run but is useful for analyzing the case of high inflation. (p. 322) Coase theorem the proposition that even in the presence of externalities an economy can always reach an efficient solution as long as transaction costs are sufficiently low. (p. 728) collusion cooperation among producers to limit production and raise prices so as to raise one another’s profits. (p. 639) command economy industry is publicly owned and a central authority makes production and consumption decisions. (p. 2) commercial bank a bank that accepts deposits and is covered by deposit insurance. (p. 257) commodity-backed money a medium of exchange that has no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods on demand.
(p. 233) commodity money a medium of exchange that is a good, normally gold or silver, that has intrinsic value in other uses. (p. 233) common resource a resource that is nonexcludable and rival in consumption. (p. 749) comparative advantage the advantage conferred if the opportunity cost of producing the good or service is lower for another producer. (p. 26) compensating differentials wage differences across jobs that reflect the fact that some jobs are less pleasant or more dangerous than others. (p. 711) competitive market a market in which there are many buyers and sellers of the same good or service, none of whom can influence the price at which the good or service is sold. (p. 48) complements pairs of goods for which a rise in the price of one good leads to a decrease in the demand for the other good. (p. 53) concentration ratios measure the percentage of industry sales accounted for by the “X” largest firms. (p. 573) constant returns to scale long-run average total cost is constant as output increases. (p. 563) consumer price index (CPI) a measure of the cost of a market basket intended to represent the consumption of a typical urban American family of four. It is the most commonly used measure of prices in the United States. (p. 144) consumer spending household spending on goods and services from domestic and foreign firms. (p. 103) consumer surplus a term often used to refer both to individual consumer surplus and to total consumer surplus. (p. 485) consumption function an equation showing how an individual household’s consumer spending varies with the household’s current disposable income. (p. 162) consumption possibilities the set of all consumption bundles that are affordable, given a consumer’s income and prevailing prices. (p. 514) contractionary fiscal policy fiscal policy that reduces aggregate demand by decreasing government purchases, increasing taxes, or decreasing transfers. (p. 205) contractionary monetary policy monetary policy that, through the raising of the interest rate, reduces aggregate demand and therefore output. (p. 310) convergence hypothesis a theory of economic growth that holds that international differences in real GDP per capita tend to narrow over time because countries with low GDP per capita generally have higher growth rates. (p. 383) copyright the exclusive legal right of the creator of a literary or artistic work to profit from that work; like a patent, it is a temporary monopoly. (p. 5
72) cost (of potential seller) the lowest price at which a seller is willing to sell a good. (p. 489-3 cost-minimization rule hire factors so that the marginal product per dollar spent on each factor is the same; a firm uses this rule to determine the cost-minimizing combination of inputs. (p. 708) cost-push inflation inflation that is caused by a significant increase in the price of an input with economy-wide importance. (p. 327) crowding out the negative effect of budget deficits on private investment, which occurs because government borrowing drives up interest rates. (p. 281) currency in circulation actual cash held by the public. (p. 231) current account see balance of payments on the current account. cyclical unemployment unemployment resulting from the business cycle; equivalently, the difference between the actual rate of unemployment and the natural rate of unemployment. (p. 130) cyclically adjusted budget balance an estimate of what the budget balance would be if real GDP were exactly equal to potential output. (p. 298) deadweight loss losses associated with quantities of output that are greater than or less than the efficient level, as can result from market intervention such as taxes, or from externalities such as pollution. (pp. 92, 506) debt deflation the reduction in aggregate demand arising from the increase in the real burden of outstanding debt caused by deflation; occurs because borrowers, whose real debt rises as a result of deflation, are likely to cut spending sharply, and lenders, whose real assets are now more valuable, are less likely to increase spending. (p. 339) debt–GDP ratio government debt as a percentage of GDP, frequently used as a measure of a government’s ability to pay its debts. (p. 301) decreasing returns to scale long-run average total cost increases as output increases (also known as diseconomies of scale). (p. 563) deductible a sum specified in an insurance policy that the insured individuals must pay before being compensated for a claim; deductibles reduce moral hazard. (p. 785) default when a borrower fails to make payments as specified by the bond contract. (p. 226) deflation a fall in the overall level of prices. (p. 12) demand curve a graphical representation of the demand schedule, showing the relationship between quantity demanded and price. (p. 49) demand price the price of a given quantity at which consumers will demand that quantity. (p. 89) demand
-pull inflation inflation that is caused by an increase in aggregate demand. (p. 327) demand schedule a list or table showing how much of a good or service consumers will want to buy at different prices. (p. 49) demand shock any event that shifts the aggregate demand curve. A positive demand shock is associated with higher demand for aggregate output at any price level and shifts the curve to the right. A negative demand shock is associated with lower demand for aggregate output at any price level and shifts the curve to the left. (p. 191) deposit insurance a guarantee that a bank’s depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account. (p. 246) depreciation of currency a fall in the value of one currency in terms of other currencies. (pp. 400, 422) depression a very deep and prolonged downturn. (p. 10) derived demand for a factor results from (or is derived from) the demand for the output being produced. (p. 681) devaluation a reduction in the value of a currency that is set under a fixed exchange rate regime. (p. 438) diminishing marginal rate of substitution the principle that the more of one good that is consumed in proportion to another, the less of the second good the consumer is willing to substitute for another unit of the first good. (p. 795) diminishing returns to an input the effect observed when an increase in the quantity of an input, while holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input. (p. 545) diminishing returns to physical capital in an aggregate production function when the amount of human capital per worker and the state of technology are held fixed, each successive increase in the amount of physical capital per worker leads to a smaller increase in productivity. (p. 376) discount rate the interest rate the Fed charges on loans to banks. (p. 263) discount window an arrangement in which the Federal Reserve stands ready to lend money to banks. (p. 246) discouraged workers nonworking people who are capable of working but have given up looking for a job due to the state of the job market. (p. 120) discretionary fiscal policy fiscal policy that is the direct result of deliberate actions by policy makers rather than rules. (p. 212) discretionary monetary policy the use of changes in the interest rate or the money supply to stabilize the economy. (p. 348) diseconom

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