review questions & answers micro all chapters-1

Technology, R&D, and Efficiency

Micro – Answers to Review Questions

B. Answers to Short-Answer, Essays, and Problems, chapter 1

3. What do economists mean when they say that “there is no free lunch”? Give another example to which this statement applies.

Anything of any value that is offered for “free” still has a cost. Economists refer to this sacrifice as an opportunity cost. In this case, the resources that were used to provide the free lunch could have been put to an alternative use. The opportunity cost is the next best alternative use for those resources. As another example, consider the case of a bank that offers you a “free” sports bag to open an account at the bank. The bag may be free to you as a new bank customer, but there is still a cost paid by the bank in the form of resources that could have been put to alternative uses. [text: E pp. 3-4; MA pp. 3-4; MI pp. 3-4]

9. Explain the importance of the ceteris paribus or “other-things-equal” assumption.

Because economics is concerned with real-world behavior, it is impossible to develop theories about economic relationships in a laboratory setting where the variables of interest could be isolated. Economists try to analyze changes in the variables of interest by finding ways to hold “other things constant or equal.”

Thus, the ceteris paribus assumption is made to indicate that these other variables are not changing or affecting the variables of interest. For example, the theory of consumer demand states that price and quantity demanded are inversely related; people will buy less at higher prices than they will at lower prices. But this theory assumes that other variables that might affect quantity demanded are not changing. This assumption is the ceteris paribus assumption. [text: E pp. 7-8; MA pp. 7-8; MI pp. 7-8]

New 13. What is policy economics? What are the three basic steps on policymaking?

Policy economics applies economic facts and principles to help resolve specific problems and to achieve certain economic goals. The three basic steps on formulating economic policy are: (1) state the goals; (2) determine the policy options to be used to achieve the stated goals; and (3) implement and evaluate the options on the basis of specific criteria important to decision makers. [text: E p. 8; MA p. 8; MI p. 8]

14. List eight widely accepted economic goals of the United States.

Eight goals are given in the text: economic growth, full employment, economic efficiency, price stability, economic freedom, equitable distribution of income, economic security, and balance of international trade. [text: E p. 9; MA p. 9; MI p. 9]

17. Below are six statements. Indicate whether each one pertains to microeconomics (MIC) or macroeconomics (MAC).

(a) “The inflation rate in the United States hit its lowest level in the last twenty years.”(b) “The profits of Microsoft rose 20 percent during the past quarter.”(c) “Rains from El Nino again hit the California region causing severe flooding in farms. The prices for citrus and produce are expected to rise sharply.”(d) “The nation’s economy grew at an annual rate of 3.7 percent in the final quarter of the year.”(e) “The trade deficit in the United States was $20 billion last month.”(f) “General Motors plans to spend $800 million on a new automobile plant.”

409


(a), (d), and (e) are macro; (b), (c), and (f) are micro. [text: E pp. 9-10; MA pp. 9-10; MI pp. 9-10]

19. Below are six statements. Identify whether each is a positive or normative statement.

(a) The minimum wage would be increased so low-income workers can earn a living wage.(b) The unemployment rate is too high and should be reduced through government actions.(c) The rate of inflation was about 2 percent last year, an all time low for the past decade.(d) The government should take action to break up the monopoly power of Microsoft.(e) Interest rates should be lower in the United States so that people can afford to build a home.(f) The Federal government achieved a budget surplus for the first time in thirty years.(a), (b), (d) and (e) are normative; and (c) and (f) are positive. [text: E p. 10; MA p. 10; MI p.10]

23. Below are four statements. Each of them is an example of one of the pitfalls often encountered in the study of economics. Indicate following each statement the type of pitfall involved.

(a) “July is the month with the most ice cream sales and also the month with the most drownings. Therefore, the more ice cream people eat, the more likely they are to drown.”(b) “Dry weather in the county where Farmer Brown lives decreased his income because his crop was so poor. Therefore, when there is dry weather in the nation as a whole all farm incomes will suffer.”(c) “I have to live within my income. Therefore, governments should not be allowed to borrow money.”(d) “National health insurance plans are socialistic.”(a) Causation is confused with correlation. (“Post hoc” fallacy.)(b) This is the fallacy of composition. What is bad for one farmer is not necessarily bad for all farmers if prices rise enough to offset the decline in crop yields overall. However, dry weather in only one county would not cause an increase in agricultural prices, so Farmer Brown would suffer if his were the only dry area.(c) This illustrates two pitfalls. The fallacy of composition may be a factor behind this statement since governments are a collection of individuals, but the fallacy is that governments do not have limited life spans and additionally have the power to tax.This statement also illustrates biased thinking since it assumes that all borrowing is bad.(d) This is an example of loaded terminology designed to influence one’s view of national health insurance plans. [text: E pp. 10-12; MA pp. 10-12; MI pp. 10-12]

New 24. What is the fallacy of composition? Give an economic and a non-economic example.

It is the incorrect reasoning that what is true for an individual (or part of a group) is necessarily true for the whole group. Or, what is true at the micro level of analysis may not be true at the macro level of analysis. Economic example: when an individual farmer produces a large crop, then the farmer should have an increased income because he or she has more output to sell. If, however, all farmers produce more output, then the increase in output may decrease prices and reduce farm income. Non-economic example: If a spectator at a packed basketball arena stands up, then he or she will likely see the game better. If, however, all spectators at the game stand up, then the group of spectators as a whole will not be able to see the game better. [text: E p. 11; MA p. 11; MI p. 11]

410


New 25. Explain what the post hoc fallacy is. Give an example.

It means “after this, therefore because of this.” It is the mistaken belief that when one event precedes another, the first event is the cause of the second. An example: I washed my car today; therefore it will rain tomorrow. [text: E pp. 11-12; MA pp. 11-12; MI pp. 11-12]

26. Explain the difference between correlation and causation and give an example.

Correlation refers to a systematic and dependable association between two sets of data (two kinds of outcomes). Causation implies that there is a cause-effect relationship between two events. Correlation does not imply causation. Just because two events are related in a predictable manner does not necessarily mean that one causes the other. More must be known about the cause-effect relationship before conclusions about causation can be drawn.

For example, one could discover a positive correlation between ice-cream sales and the number of drownings. However, this does not mean that eating ice cream causes drowning, nor does it mean that more drownings cause people to buy ice cream! [text: E p. 12; MA p. 12; MI p. 12]

D. Answers to Appendix Questions

31. Define what is meant by a positive or direct relationship between two variables and describe the line graph depicting such a relationship.

A positive or direct relationship between two variables describes a situation where the two variables change in the same direction. If the first variable increases, the second variable increases; if the first decreases, the second decreases. An example would be individual income and spending. Generally, high spending is associated with high incomes and lower spending is associated with lower incomes. The line graph of a direct, positive relationship is upward sloping from left to right. [text: E pp. 15-16; MA pp. 15-16; MI pp. 15-16]

32. Define what is meant by an inverse relationship between two variables and describe the line graph depicting such a relationship.

An inverse relationship describes a situation where the two variables change in opposite directions. When the first variable increases, the second variable decreases and vice versa. An example would be product price and quantity demanded of the product. Other things being equal, the higher the product price, the less will be purchased. The line graph of an inverse relationship has a negative slope; that is, it is downward sloping from left to right. [text: E pp. 15-16; MA pp. 15-16; MI pp. 15-16]

33. Differentiate between the independent and dependent variables in an economic relationship.

The dependent variable changes as a consequence of the change in the independent variable. By specifying one variable as the dependent variable, a causal relationship is implied with changes in the independent variable causing changes in the dependent variable. The dependent variable is the “effect” or outcome. [text: E pp. 16-17; MA; pp. 16-17; MI pp. 16-17]

The slope at point A is 5/5 = 1, at B it is zero, at C it is -5/5 = -1. To find these slopes divide the vertical distance of the tangent by the horizontal distance. At point C the line

411


slopes down, so the vertical distance is negative when the horizontal direction is positive. [text: E p. 19; MA p. 19; MI p. 19]


2. List the four resource categories and give a brief description of each.

(a) Land: natural resources including land, forests, water and minerals.(b) Capital: investment goods or those manufactured items used in production of other goods. Factories, tools, machinery, transportation facilities, and equipment are examples. Money is not a capital good.(c) Labor: a broad term used to describe the physical and mental talents of men and women available to be used in producing goods and services.(d) Entrepreneurial ability: a type of human resource, but unique from productive labor in that it refers to the person who is the driving force behind production decisions, innovation, and the one who is willing to take the risk of time, effort, reputation, and/or funds. [text: E p. 23; MA p. 23; MI p. 23]

5. Explain and evaluate: “If resources were infinitely abundant in relation to the demand for them, the economizing problem would dissolve in a sea of affluence.”

If this were true, people would not have to make choices and there would be no need for economic systems to distribute the goods and services produced. In a world of abundance, people could simply help themselves to whatever they wanted. [text: E pp. 22-24; MA pp. 22-24; MI pp. 22-24]

9. Differentiate between allocative efficiency and productive efficiency.

Allocative efficiency means that resources are used for the goods and services most wanted by society. For example, if society wants compact discs instead of cassette tapes, then compact discs should be produced with resources rather than cassette tapes. Productive efficiency means that the least costly production techniques are used once decisions are made about what will be produced. [text: E pp. 24-25; MA pp. 24-25; MI pp. 24-25]

New 12. The production possibilities curve below show the hypothetical relationship between the production of food and clothing in an economy.

(a) What is the marginal opportunity cost of producing the second unit of clothing?(b) What is the total opportunity cost of producing the second unit of clothing?(c) What is the marginal opportunity cost of producing the third unit of clothing?(d) What is the total opportunity cost of producing the third unit of clothing?

Combination Food Clothing A 0 4B 7 3C 13 2D 18 1E 22 0

(a) 5 units of food (18 – 13 = 5); (b) 9 units of food (22 – 13 = 9); (c) 6 units of food (13 – 7 = 6); (d) 15 units of food (22 – 7 = 15). [text: E: pp. 25-27; MA: pp. 25-27; MI: pp. 25-27]

15. What is the economic rationale for the law of increasing costs?

412


Economic resources are not completely adaptable to alternative uses. In a two-product (A and B) economy, an increase in the production of product A will cause a reduction in the quantity of product B that can be produced because resources are being reallocated from the production of B to A. That reallocation of resources is not constant and becomes increasingly costly in terms of the lost production of B. As more resources shift from the production of B to A, these resources are less and less adaptable or suitable for the production of A. The production of more and more of A entails an increasing opportunity cost in the form of less and less production of B. [text: E p. 27; MA p. 27; MI p. 27]

18. In the following graph, explain the relationship between marginal cost and marginal benefit at 1 million units of output, 2 million units of output, and 3 million units of output for the production of computers. In your explanation discuss the overallocation of resources, underallocation of resources, and optimal allocation of resources for the production of computers.

At 1 million units of output, the marginal cost is $4 and the marginal benefit is $12. There is underallocation of resources to computer production. For each additional computer produced up to 2 million, the marginal benefits are greater than the marginal costs. At 2 million units of output, the marginal cost is $8 and the marginal benefit is $8. This point represents allocative efficiency and would be the optimal level of output. The benefits of an additional unit of output just equal the additional cost at this level of production. At 3 million units of output, the marginal cost is $12 and the marginal benefit is $4. There is an overallocation of resources to computer production at this level of output. Society would be better off if there was less output. In fact, production of each unit after 2 million has a marginal cost that is greater than the marginal benefit. [text: E p. 28; MA p. 28; MI p. 28]

22. What do economists mean when they state that investment is spending on “goods for the future”?

It is easiest to explain this statement by realizing that consumption is spending on goods and services for the present. The resources that are not used for consumption can be devoted to goods or services that can be used in future production. For example, investment in education, machinery, factories, equipment, and tools are types of spending that will be used in expanding production of consumer goods and services in the future. [text: E p. 31; MA p. 31; MI p. 31]

26. Describe the adjustments in the production possibilities curves in each of the following situations for the U.S. economy.(a) the economy moves from full employment into a deep recession(b) the economy makes great strides in eliminating discrimination

413


(c) the end of the cold war leads to cuts in military spending(d) Congress significantly increases government spending for health and education(a) The economy begins at a point on the curve but with recession there is unemployment and the economy now operates at a point in the area inside the curve, indicating that production is less than that which is possible because some resources are not being used.(b) Eliminating discrimination would move the economy from a point inside its production possibilities curve toward a point on the curve.(c) If the curve is illustrating the tradeoff between private spending and government spending (or between military and consumer goods), then this should mean a movement along the curve in the direction of more private or consumer production and less military production. Government spending in general could decrease, but if that were not the case, then the government might simply shift some funds from the military to other types of government spending and the point would not necessarily move at all on a curve depicting the tradeoff between government and private spending.(d) Movement depends on where the money is coming from. If the money comes from increased taxes or borrowing, then there is a movement along the curve away from private spending and toward public spending. If the money comes from other government programs and the curve is illustrating government versus private spending, the amount of total government production would not necessarily change, so the point could remain at the same spot on the curve. [text: E pp. 32-33; MA pp. 32-33; MI pp. 32-33]

28. Explain the term “laissez faire capitalism.”

Pure capitalism is sometimes called “laissez faire” capitalism which is a French term for “let it be.” In pure capitalism the government’s role is limited to protecting private property and establishing the legal framework for free enterprise and free markets to function. [text: E p. 33; MA p. 33; MI p. 33]


New 4. Give three explanations for the law of demand:

First, it is explained by common sense. People tend to buy more of a product at a lower price than at a higher price. Second, there is diminishing marginal utility: a decrease in satisfaction that results with an increase in the amounts of a good or service. The second unit of a good yields less satisfaction (or utility) than the first. Third, there are income and substitution effects. With an income effect, a lower price increases the purchasing power of money income, enabling you to buy more at lower price. With a substitution effect a lower price gives an incentive to substitute the lower-priced good for a now relatively high-priced good. [text: E p. 41; MA p. 41; MI p. 41]

7. List five basic determinants of market demand that could cause demand to decrease. (The text mentions seven possibilities.)

(a) Consumers’ tastes become less favorable toward the item.(b) The number of buyers decreases.(c) Incomes fall and the item is a normal good.(d) Incomes rise and the item is an inferior good.(e) A decrease in the price of a substitute product.(f) An increase in the price of a complementary product.(g) Consumers expect lower prices in the future. [text: E pp. 43-46; MA pp. 43-46; MI pp. 43-46]

414


12. Suppose a producer sells 1,000 units of a product at $5 per unit one year, 2,000 units at $8 the next year, and 3,000 units at $10 the third year. Is this evidence that the law of demand is violated? Explain.

No. The law of demand shows the relationship between price and quantity demanded. In general, as price falls the quantity demanded will increase. One of the assumptions, however, is that all other things are equal or held constant. In this case, this assumption may have been violated and that is why it seems there is a positive relationship between price and quantity. The most likely explanation for the set of events is that demand for the product increased from one year to the next. IF that was true, then price would rise and the equilibrium quantity would increase. [text: E. pp. 41-42; MA pp. 41-42; MI pp. 41-42]

13. What effect should each of the following have upon the demand for portable CD-ROM players? Explain your reasoning in each case.(a) the development of improved, low-priced DVD players that compete with CD-ROM players(b) an increase in population and incomes(c) a substantial increase in the number and quality of CD-ROM music(d) consumer expectations of substantial price increases in CD-ROM players(a) Would cause a decrease in demand for CD-ROM players, assuming that DVD players are substitutes for CD-ROM players.(b) Would cause an increase in demand because there are more consumers and they have more income to spend. This assumes that CD-ROM players are a normal good and more would be bought with higher incomes.(c) Should increase demand since increased number and quality of CD-ROM music’s variety of programs should make owning a CD-ROM player more desirable.(d) Should increase current demand because expectations about the future have changed and may prompt them to “buy now” to beat the future price increase. [text: E pp. 43-45; MA pp. 43-45; MI pp: 43-45]

New 15. Describe and give a reason for the law of supply.

The law of supply indicates that producers will produce and sell more of their product at a high price than at a low price. This means that there is a direct relationship between price and quantity supplied. The basic explanation is that, given product costs, a higher price means greater profits and thus more incentive for business to increase the quantity supplied. [text: E p. 47; MA p. 47; MI p. 47]

17. The U.S. Congress is considering passing an excise tax that would increase the price of a pack of cigarettes by $1.00. What would be the likely effect of this change on the demand and supply of cigarettes? What is likely to happen to cigarette prices and the quantity consumed if the tax bill is enacted?

In the short run, the excise tax would decrease the supply of cigarettes because in essence it increases the cost of production. The decrease in supply would increase the price of cigarettes and decrease the quantity of cigarettes consumed. The demand for cigarettes would not change, but the quantity demanded would decrease. [text: E pp. 48-49; MA pp. 48-49; MI pp. 48-49]

19. Newspaper item: “Due to lower grain prices, consumers can expect retail prices of choice beef to begin dropping slightly this spring with pork becoming cheaper after midsummer,” the Agriculture Department predicted. “This reflects increasing supply,” the department said. Does the statement use the term “supply” correctly? What effects might this announcement have on consumer demand? Explain.

415


The announcement does use the term “supply” correctly because the drop in price predicted is a result of lower resource (grain) prices. This means that producers of beef and pork will lower prices for each quantity on the existing supply schedule assuming “all other things remain equal.”

Consumer demand at present might decrease as consumers wait to make big purchases of beef and pork in the future when prices are predicted to drop. By spring, if beef prices drop, there should be an increase in the quantity of beef demanded and probably a decrease in the demand for pork, which is a substitute for beef. By midsummer, if pork prices drop, there will be an increase in the quantity of pork demanded, and depending on what is then happening with beef prices, a decline in the demand for beef. If beef prices had continued to fall, it is hard to say whether there would be much of a change in demand due to the price of the substitute pork falling. More likely, there would be only a movement along the curve for beef if the price continued to fall. [text: E pp. 43-49; MA pp. 43-49; MI pp. 43-49]

21. Given the products below and the events that affect them, indicate what happens to demand, supply, equilibrium quantity, and equilibrium price. Identify the determinant of demand and supply that causes the shifts.(a) Calculators. More schools require students to buy and use calculators; improved productivity shortens the time it takes to make calculators.(b) Gasoline. Oil production declines due to a crisis in the Middle East; people take more car vacations and drive more.(c) New homes. The average incomes fall as the economy moves into recession; the productivity of home construction workers and builders increases.(a) The demand for calculators increases because of an increase in the number of buyers. The supply of calculators increases because of a fall in resource prices (productivity reduces resource costs). The equilibrium quantity increases, but what happens to the equilibrium price is indeterminant and depends on the magnitudes of the shifts.(b) The supply of gasoline increases because of a rise in resource price (oil prices increase due to a cutback in production). The demand for gasoline increases due to an increase in the taste for taking driving vacations. The equilibrium price increases, but what happens to the equilibrium quantity is indeterminant and depends on the magnitudes of the shifts.(c) The demand for new homes decreases because of a decline in consumer incomes. The supply of new homes increases because of a fall in the price of labor resources (productivity increases reduce resource costs). The equilibrium price decreases, but what happens to the equilibrium quantity is indeterminant and depends on the magnitudes of the shifts.

27. In the space below each of the following, indicate the effect [increase (+), decrease (–)] on equilibrium price (P) and equilibrium quantity (Q) of each of these changes in demand and/or supply.

P Q(a) Increase in demand, supply constant ________ ________(b) Increase in supply, demand constant ________ ________(c) Decrease in demand, supply constant ________ ________(d) Decrease in supply, demand constant ________ ________(a) +, +; (b) –, +; (c) –, –; (d) +, – [text: E pp. 52-53; MA 52-53; E pp. 52-53]


New 2. Why is the right of private property an essential characteristic of a market system?

416


Property rights are important because they give people private ownership of resources. This ownership encourages them to make the best use of those resources because they will benefit if they do. Property rights also encourage people to take the risk of investing in capital goods or to develop new innovation or products because they will receive the benefits from this activity if they are successful. Property rights offer incentives for people to maintain their property to preserve its value and invest in it if they think they can increase its value. Property rights also facilitate exchanges by making clear who owns a resource so that there is no question about the legitimacy of the transaction. [text: E pp. 59-61; MA pp. 59-61; MI pp. 59-61]

3. What role does freedom play in capitalism? How important is it to the operation of a competitive market economy?

In capitalism, two essential freedoms are the freedom of enterprise and freedom of choice. Business must be free to get economic resources, organize them to produce products, and sell them in the market. Businesses must also be free to enter or leave an industry. Freedom of choice gives business owners, resource owners, and consumers freedom to act to advance their own self-interest. Business owners are free to buy and sell property. Labor resources (workers) can enter or exit any line of work for which they are qualified. Consumers are free to purchase goods and services as they choose based on their budget constraints. Without these freedoms it would be impossible for a market economy to exist. [text: E p 60; MA p. 60; MI p. 60]

New 4. Explain the importance of self-interest in the operation of a market system.

Self-interest is the motivating force behind both the demand and supply sides of the product and resource markets in a capitalist system. Entrepreneurs engage in production with the expectation of making a profit; workers seek the best wage and working conditions they can get; consumers allocate their spending in order to maximize their satisfaction. [text: E pp. 60-61; MA pp. 60-61; MI pp. 60-61]

New 5. What is the importance of competition in relation to self-interest in a market system?

Competition is important as the force which tempers or regulates the greed or self-interest of the producers, sellers, workers, and buyers. If producers make too much profit, competitors will arise to take advantage of the opportunity and as production increases, prices and profits will fall. If workers demand too much, employers will seek other workers who are willing to work for less. If buyers are not willing to pay a fair price for the product, producers will sell the product to someone who is. In each case it is competition or the threat of competition that tempers the greed of the economic “player.” [text: E p. 61; MA p. 61; MI p. 61]

11. What are the economic advantages of specialization?

The advantages come from increased productivity or output per worker as specialized workers gain skills in performing one task. Therefore, more is produced with the same amount of resources as before specialization. [text: E p. 62; MA p. 62; MI p. 62]

16. Suppose Tom, Dick, and Harry live in a barter economy. Tom produces wine, Dick bakes bread, and Harry makes cheese. Tom wants some bread to go with his wine and is willing to trade 1 gallon of wine for two loaves of bread. Dick wants some cheese to go with his bread and is willing to trade one loaf of bread for one-half pound of cheese. Harry doesn’t want bread, but wants some wine to go with his cheese and is willing to trade cheese for one gallon of wine. It is not possible for all three of them to meet together at one time.(a) Explain how this situation illustrates the difficulty with a barter economy.

417


(b) Devise a money system using precious stones where four stones are equivalent in value to one gallon of wine. In other words tell how much bread and cheese would be worth in terms of stones in this economy. In this system, how much cheese must Harry sell in order to buy one gallon of wine?(a) The lack of coincidence of wants is illustrated in this situation. Tom wants the bread that Dick has, Dick wants Harry’s cheese, and Harry wants Tom’s wine but for any two of them there is no incentive to trade for something each does not want. In other words, there is no coincidence of wants.(b) If precious stones could be used as a medium of exchange, Tom could receive four stones for each gallon of wine. According to their initial exchange values, he should be willing to pay two stones for each loaf of bread. Dick would then have four stones to purchase one pound of cheese and Harry could buy wine with the four stones he earned from selling this cheese. In terms of stone prices, bread is worth two stones per loaf and one gallon of wine and one pound of cheese are each worth four stones in this economy. [text: E pp. 62-63; MA pp. 62-63; MI pp. 62-63]

18. Distinguish between normal and economic profits.

A normal profit can be explained as the normal return that an entrepreneur must receive to cover the cost of the functions he or she performs in organizing and combining resources in the firm. It is a cost payment for the entrepreneurial ability and time invested in the business. An economic profit is any return above all costs including the normal profit or return that the entrepreneur must receive. It is sometimes called “pure” profit because it is over and above the return necessary to operate the business. [text: E p. 64; MA p. 64; MI p. 64]

19. Assume that a firm can produce product A, product B, or product C with the resources it currently employs. These resources cost the firm a total of $100 per week. Assume, for the purposes of this problem, that the firm’s costs cannot be changed. The market prices and the quantities of A, B, and C these resources can produce are given as follows.

Product Market price Output Profit A $14.00 10 $_____B 9.00 11 _____C .50 300 _____

(a) Compute the firm’s profit when it produces A, B, or C and enter these data in the table.(b) Which product will the firm produce?(c) If the price of A rose to $16, which product will the firm produce?(d) If the firm produces A at a price of $16, what would tend to happen to the number of firms producing product A?

418


Product Market price Output Profit A $14.00 10 $40B 9.00 11 –1C .50 300 50

(a) Profit for A will be $40; for B will be –$1 (loss); for C will be $50.(b) Firm will produce product C.(c) If the price of A rises (assuming the firm can sell all of its output at the new price), it would make a profit of $60 on A and so would produce product A.(d) If other firms face similar costs, more firms would enter industry A to take advantage of the higher economic profits. [text: E pp. 64-65; MA pp. 64-65; MI pp. 64-65]

23. Why does competition force firms to use the least-cost, most efficient, productive techniques?

If firms do not use the most efficient techniques, their rivals who do use more efficient methods will be able to charge lower prices and potentially take buyers from the less efficient seller. If the less efficient firm has to lower prices to match the competition without improving efficiency, it will eventually realize losses and in the long term will have to leave the industry unless it, too, uses the most efficient production methods. [text: E p. 66; MA p. 66; MI p. 66]

26. What is meant by the guiding function of prices?

The guiding function of prices refers to the response of producers to changes in prices. With a given supply schedule, if demand increases, the market equilibrium price will rise and producers will respond to that by producing an increased quantity of the product. Also, there may be entry of firms into the industry. Conversely, if demand decreases, the market equilibrium price will fall and producers will respond to that change by producing a decreased quantity of the product. There may also be an exodus of firms from the industry. The market system is a communications system and prices are the way information is communicated and incentives are given to take action. [text: E p. 67; MA p. 67; MI p. 67]


1. Name the categories used in describing the functional distribution of income. Tell which type receives the largest share and approximately how much this is in fraction or percentage terms.

The categories are wages and salaries, proprietors’ income, corporate profits, interest, and rents. Wages and salaries are by far the largest share comprising seventy percent of the total (70%). (If we recognize that part of proprietor’s income is also a form of income to labor resources, then labor’s share is even larger, perhaps about 80%.) [text: E pp.73-74; MA pp.73-74; MI pp.73-74]

3. How do households dispose of their income? Identify the three major ways income is disposed of and the relative share for each category.

Household income is disposed of in three ways. First, income is paid to the government as taxes. Second, some household income is saved. The great majority of household income, however, is used for personal consumption of goods and services. In 2000, 84% of income went for personal consumption expenditures, 16 % went for personal taxes and 0% went to personal saving. [text: E pp. 74-75; MA pp. 74-75; MI pp. 74-75]

419


5. Describe the business population. What is the difference between a plant, a business firm, and an industry?

The business population of the American economy consists of three major types of entities. A plant is a physical structure that produces a product. A business firm is an organization which owns and operates plants. (Multiplant firms may be horizontally integrated, vertically integrated, or conglomerates.) An industry is a group of firms producing the same or similar goods or services. [text: E p. 76; MA p. 76; MI p. 76]

8. What are the three principal legal forms of business firms? What are the advantages and disadvantages of each?

The three principal legal forms of business firms are the proprietorship, partnership and corporation. Each has special characteristics and advantages and disadvantages. The proprietorship is easy to form, lets the owner be boss, and allows great freedom. The disadvantages are the lack of access to large amounts of financial capital, the difficulty of managerial specialization, and the unlimited liability of the owner. The partnership is also easy to form, and allows for more access to financial capital and permits more managerial specialization. The potential disadvantages are that partners may disagree, there are still limits to financial capital or managerial specialization, continuity of the firm over time is a problem, and there is unlimited liability for partners. The corporation can raise financial capital through the sale of stocks and bonds, has limited liability for owners, can become large in size, and has an independent life. The chief disadvantages are the double taxation of some corporate income, potential for abuse of this legal entity, and legal or regulatory expenses. There can also be a principal-agent problem with the separation of ownership and control of the firm. [text: E pp. 76-78; MA pp 76-78; MI pp. 76-78]

11. Define what is meant by a corporation and give two reasons why corporations dominate the American business sector.

Corporations are legal business organizations which are distinct and separate entities from the individuals who own them. As such, corporations are treated as legal persons that can acquire resources, own assets, produce and sell products, incur debts, extend credit, sue and be sued, and carry on all functions which any other form of enterprise performs.

Corporations dominate the business sector in terms of sales because they are the most effective form of business for raising money capital with their ability to issue stocks and bonds. Therefore, the largest businesses tend to be corporations. Stockholders also have the advantage of limited liability which is important when there is much at risk, so again the larger firms have an incentive to incorporate. [text: E pp. 77-78; MA pp. 77-78; MI pp. 77-78]

13. Explain what “separation of ownership and control” of the modern corporation means. How is this situation a principal-agent problem?

In many large modern corporations there are thousands of stockholders, each with a very small share of the company. They have little or no power to make decisions in the corporation and only have the power to cast their share votes on a few decisions at the annual meeting of shareholders. The day-to-day decisions involving the corporation are made by the paid professional managers. In many cases, even the board of directors elected to represent the shareholders are largely at the mercy of management recommendations when it comes to making policy regarding the company. Thus, the shareholders of a large corporation are separated from the control of the corporation they own. This situation is an example of a principal agent problem where the interests

420


of the principals (stock holders) differ from the interests of agents (managers). [text: E p. 78; MA p. 78; MI p. 78]

14. Classify each of the following specific policy actions in terms of the five basic functions of government. Justify your classification in each case.(a) Government expenditures for military and space research(b) Amending the existing social security system to provide “catastrophic health insurance” for long illnesses(c) The establishment of the Federal Trade Commission to police false and misleading advertising(d) State subsidies to local school districts(e) A Federal excise tax on gambling(f) A program to distribute surplus agricultural products to poor families(a) This is a reallocation of resources from the private sector to the public sector to provide for public goods in the form of military and space research which is both indivisible and would have a free-rider problem if left to private sector production. [text: E pp. 80-82; MA pp. 80-82; MI pp. 80-82](b) This is an example of redistribution of income from all those who are able to pay a portion of the amount needed for this insurance fund to those who would be unable to pay for a long catastrophic illness. One might also argue that there is some degree of reallocation of resources from private spending to public health insurance because of the perceived spillover benefits in providing health care to those who cannot afford it as well as those who can. There are spillover benefits to promoting health and welfare among all families, not just those who are able and willing to pay the cost of private catastrophic health insurance. [text: E pp. 79-80; MA pp. 79-80; MI pp. 79-80](c) This is primarily an example of government’s role in providing the legal framework conducive to a healthy market system. It is also part of the government’s role in maintaining competition. Without such regulation, some firms may gain monopoly control by unfair trade practices. [text: E p. 79; MA p. 79; MI p. 79](d) This is an example of reallocating resources to subsidize the cost of public education because there are substantial spillover benefits for the entire state when there is a good educational system in place. It also is an example of the government’s role in redistributing income if the subsidies to poor school districts exceed tax collections from those districts. [text: E pp. 80-82; MA pp. 80-82; MI pp. 80-82]

(e) This is an example of the government’s role in deterring an undesirable activity. It also is an example of redistribution of income from those who earn income from gambling to the public sector. There is some feeling that income from gambling is a type of unearned income and therefore, perhaps less deserved than other forms of income. Therefore, from a fairness perspective redistribution from those private individuals who earn income from gambling to public programs is viewed as desirable. [text: E pp. 80-82; MA pp. 80-82; MI pp. 80-82](f) This program redistributes income to two groups from taxpayers. By buying the surplus agricultural products in the first place, the government is redistributing income from taxpayers to farmers. Then distribution of this surplus to poor families is an in-kind redistribution of income from taxpayers to poor families. There is some reallocation of resources to the agricultural sector from other private sector production since government purchase of surplus products increases demand in agriculture. [text E pp. 79-80; MA pp. 79-80; MI pp. 79-80]

15. “A society has every right to reject the distribution of income which is automatically formed by the market system.” Do you agree? Justify your position.

One would probably agree with this statement for the reasons given under the section in the chapter on the government’s role in redistributing income. A democratic society has

421


a sense of fairness and equal opportunity for all. Therefore, we feel we should provide for the less fortunate among us.

Also, one could justify this position based on more selfish reasons. It is in society’s self-interest to have a healthy, educated productive populace. The market system will not always provide for this on its own because of the possibility of spillover costs such as pollution or spillover benefits such as education. [text: E pp. 79-82; MA pp. 79-82; MI pp. 79-82]

17. Explain what is meant by the term “market failure” by giving two major types of such failures. Then explain the reasons behind each type of failure.

A market failure is a situation where the competitive market system on its own would either (1) produce the “wrong” amount of certain goods and services as is the case where there are spillover costs or benefits, or (2) fail to allocate any resources to the production of certain goods and services referred to as “public” or “social” goods.

Where spillover or external costs exist, the market system without any intervention will allow some of the costs of private production or consumption to “spill over” onto third parties. There is no market incentive to absorb all of the costs of production if there is a way to get someone else to pay for them. In such cases of spillover costs, the market cost and price of the product will be too low and thus the quantity produced too high in terms of its true cost of production. Resources are overallocated to the production of such goods. Likewise, in the case of spillover benefits there is no incentive for the private consumer to pay for any more than the benefits that they receive as individuals. However, there may also be benefits that exist for society as a whole. Relying on the market alone will not provide the additional benefits that society would like from these products, and resources are underallocated where spillover benefits exist.

In the case of public goods and services, it is impossible to divide the product into individual saleable units for consumers to purchase and, additionally, the exclusion principle doesn’t apply. That is, even if the product could be sold, consumers would not want to purchase it because “free riders” would take advantage of their purchase. People could receive the benefits without paying for the product. In such cases, there is no incentive for individuals to purchase the item on their own even though they may desire the good or service. These are public goods and services and their provision is made possible through government purchases where tax revenues can be used to provide the product. [text: E pp. 80-82; MA pp. 80-82; MI pp. 80-82]

18. Define spillover cost and give an example.

When production or consumption of a commodity inflicts costs on third parties without compensation there is a spillover cost. Examples of spillover costs of production are primarily various forms of pollution. Spillover costs of consumption might include such things as a noisy neighbor whose habits lower neighborhood property values. [text: E pp. 80-81; MA pp. 80-81; MI pp. 80-81]

20. Explain the exclusion principle and the free-rider problem and how they are related.

Most private goods and services are subject to the exclusion principle which is the idea that those who pay for the product are the ones who get it, but those who don’t pay for it are excluded from the benefits provided by that product.

The free-rider problem exists when the exclusion principle does not apply. That is, people can receive benefits from a product without contributing to its costs. For

422


example, citizens receive benefits from a country’s national defense whether or not they pay for it. [text: E pp. 81-82; MA pp. 81-82; MI pp. 81-82]

24. Differentiate between government purchases of goods and services and government transfer payments.

Transfer payments are government payments such as unemployment compensation, social security benefits, welfare payments, and Medicare benefits. They are called transfer payments because they are essentially transferring funds from revenue accounts to those entitled to receive them. No current production is being performed by the recipients. Government purchases of goods and services such as military products and public employees’ salaries represent payment for the goods and services produced for the public sector. [text: E pp. 84-85; MA pp. 84-85; MI pp. 84-85]

25. How is total government spending defined? What is its size in the economy?

Total government spending consists of government purchases of goods and services and transfer payments. Each has a different effect on the economy. Purchases are exhaustive because they directly use the economy’s resources while transfers are nonexhaustive. Total government spending is equal to about one-third of domestic output. [text: E pp 84-85; MA pp. 84-85; MI pp. 84-85]

New 26. List the four main categories of Federal spending.

The four main categories of Federal spending are pensions and income security programs, national defense, health care and interest on the Federal debt. In 1999, about 39% of Federal expenditures went for pensions and income security, 19% went for health care, 16% went for national defense, and 14% went for interest on the national debt. [text: E p. 85; MA p. 85; MI p. 85]

New 27. List the four major sources of Federal revenues.

The four main sources of revenue are the personal income tax, payroll taxes, corporate income taxes, and excise taxes. In 1999, the personal income tax accounted for 48% of tax revenues. Payroll taxes accounted for 35% of tax revenues. Corporate income taxes were 10% of revenues. Excise taxes were 4% of tax revenues. [text: E pp. 86-87; MA p. 86-87; MI pp. 86-87]

28. Explain the difference between marginal and average tax rates.

Average tax rates are calculated by taking the total tax paid and dividing by the total income. In other words, the comparison is between two dollar amounts: total tax paid and total income. On the other hand, the marginal tax rate is a comparison of the difference in tax paid relative to the change in income which causes that differential. In other words, it is a comparison of two incremental amounts or differences. Marginal tax rates are calculated by taking the change in the tax paid and dividing by the associated change in income. [text: E pp. 86-87; MA pp. 86-87; MI pp. 86-87]


2. “The best indicator of the importance of a nation’s world trade is the ratio of its exports plus imports to the size of its domestic output.” Critically evaluate.

Certainly this is a good indicator, but not the only one. If the ratio is very large, that would indicate that world trade is very important in that nation. However, in a nation such as the United States, when imports and exports are summed and compared to GDP, the ratio is less than 30%. Yet trade is still very important since we depend almost

423


entirely on imports for some raw materials which are not available in the United States. [text: E pp. 94-95; MA pp. 94-95; MI pp. 94-95]

3. Suppose all American international trade suddenly ceased. What would be the consequences domestically? Internationally?

Our GDP would be affected to a great extent. In 2000, exports were 12% of GDP — too great a proportion to be absorbed quickly in the domestic market. Imports were about 17% of GDP. The loss of imports would mean a decline in living standards and increased purchase of higher priced U.S. goods where they could be produced. It would also result in a loss of some products altogether such as coffee, tea, nickel, tin, and others. The decline in GDP would mean a decline in productivity and employment in those industries affected. These conditions would probably cause further declines in output and employment in other industries as well.

Internationally, the world would also see a decline in living standards since the United States is the world’s largest importer and exporter. Without U.S. expenditures on their products, other nations would suffer. Without U.S. exports, their living standards would decline. [text: E pp. 94-96; MA pp. 94-96; MI pp. 94-96]

9. Explain the principle of comparative advantage in nontechnical terms.

If two nations do not have identical costs of production, then each nation should specialize in production of the good or goods which it can produce at the relatively lower cost. The key term is “relative” since one nation may be able to produce everything at an absolutely lower cost.

It is sometimes easier to explain in terms of individuals. If a doctor is a very good house painter, and can paint her house twice as fast as any professional painter, this does not mean she should paint her own house from the standpoint of comparative advantage. A doctor’s time is worth substantially more than a painter’s time, so from a relative standpoint, it makes sense to hire the painter to paint the house even if it takes him twice as long as the doctor. The doctor stands to gain economically by practicing medicine during the time it would take her to paint the house. [text: E pp. 98-99; MA pp. 98-99; MI pp. 98-99]

12. The countries of Macrostan and Micrastan have the production possibilities tables for sheep and hogs shown in the tables below. Without trade Macro would produce at Alternative D and Micra would also produce Alternative D. Note that the costs of producing sheep and hogs are constant in both countries.

Macrostan’s Production Possibilities TableProduct Alternative

(lbs) A B C D E F Sheep 25 20 15 10 5 0Hogs 0 5 10 15 20 25

Micrastan’s Production Possibilities TableProduct Alternative

(lbs) A B C D E F Sheep 20 16 12 8 4 0Hogs 0 3 6 9 12 15

(a) In Macro, the cost of producing:5 units of sheep is ______ hog units.1 unit of sheep is ______ hog units.

424


(b) In Micra, the cost of producing:4 units of sheep is ______ hog units.1 unit of sheep is ______ hog units.

(c) Which country has the comparative advantage in sheep production and which country has the comparative advantage in hog production?(d) If each nation specializes in the product where it has a comparative advantage and trades with the other, what will be the limits to the terms of trade for each sheep unit?(e) If the nations do not specialize and trade but remain at alternative D in Macrostan and D in Micrastan, the combined production of Macro and Micrastan will be how many sheep and how many hogs?(f) However, if the two nations specialize, the combined production of Macro and Micrastan will be how many sheep and how many hogs?(g) What will be the total gain of sheep and hogs if the countries specialize and trade?

(a) In Macro, the cost of producing:5 units of sheep is 5 hog units.1 unit of sheep is 1 hog units.

(b) In Micra, the cost of producing:4 units of sheep is 3 hog units.1 unit of sheep is 3/4 hog units.

(c) Based on the opportunity cost of producing in each country, Macrostan has a comparative advantage in sheep while Micrastan has a comparative advantage in hogs.(d) If each nation specializes in production where it has a comparative advantage and trades with the other, the limits to the terms of trade will be between 3/4 and 1 hog unit for each sheep unit (or conversely between 4/3 and 1 unit of sheep for each unit of hogs).(e) If the nations do not specialize and trade but remain at alternative D in Macrostan and D in Micrastan, the combined production of Macrostan and Micrastan will be 18 sheep and 24 hog units.(f) However, if the two nations specialize, the combined production of Macro and Micrastan will be 20 sheep and 25 hog units.(g) Total gains from specialization will be 2 sheep and 1 hog unit (20-18 sheep and 25-24 hogs). [text: E pp. 99-101; MA pp. 99-101; MI pp. 99-101]

14. What are the economic effects of a depreciation of the dollar on foreign exchange markets?

Depreciation means that it takes more dollars to buy foreign currencies. This means that foreign goods become more expensive to Americans and imports should decline as Americans shift to spending more on U.S. products. It also means that foreign consumers can obtain more dollars with their currency and therefore, foreign purchases of American exports abroad should rise. Both of these outcomes should stimulate the demand for American goods and expand the U.S. economic output. [text: E pp. 102-103; MA pp. 102-103; MI pp. 102-103]

23. Why do governments often intervene in international trade to restrict imports and expand exports?

Governments may intervene in trade between nations because they mistakenly think of exports as helpful and imports as harmful for a national economy. In fact, there are important gains from trade in the form of the extra output obtained from abroad. Trade makes it possible to obtain a product at a lower cost than would be the case if they were produced using domestic resources, and the earnings from exports help a nation pay for these lower-cost, imported products. Another reason why governments interfere with free trade is based on political considerations. Groups and industries seek protection from foreign competition through tariffs and import quotas, or other kinds of trade

425


restrictions. The costs of trade protectionism are hidden from consumers of the protected product so there is little opposition to demands for protectionism. [text: E pp. 104-105; MA pp. 104-105; MI pp. 104-105]

28. What is NAFTA? What have critics and defenders said about it?

NAFTA is the North American Free Trade Agreement. It formed a trade bloc among the United States, Canada, and Mexico in 1993. This agreement eliminated tariffs among these three nations. Critics in the United States say that it has decreased jobs and that it may become a base for tariff-free imports from Asian nations. Defenders say that it will allow each nation to specialize according to comparative advantage. The act will encourage more investment in Mexico, thus increasing Mexico’s productivity and national output. This result will give Mexico more funds to purchase goods and services from the United States, thus increasing jobs in this nation. [text: E p. 108; MA p. 108; MI p. 108]


New 2. The owner of a health club asks you for advice about whether the company should raise or lower the price of its membership this year based on the following information: last year the club raised the price of its membership by 5% and the number of members paying the same fee fell by 7%.

The formula for the price elasticity of demand indicates the demand for memberships is price elastic or 1.4 in this case (7 divided by 5). This result suggests that total revenues for the club should have decreased last year. Another increase in price this year would only decrease total revenues. You should advise the owner to lower membership prices because it should increase total revenue given that the membership price is in the elastic range. [text: E pp. 377-380; MI pp. 119-122]

4. Ford Motor Company announced a major rebate program for its cars and trucks. The rebate program amounts to a simple reduction in price. The company executives hope to increase revenue as a result of this rebate program. What economic explanation would justify this decision?

The company executives believe that the price decrease will increase total revenue. In this case, the executives must think that demand is elastic in this price range. When demand is elastic, a cut in price will increase total revenue. [text: E pp. 378-380; MI pp. 120-122]

6. The president of the Micro Brewing Corporation asks you, as the company economist, to forecast changes in consumer beer purchases associated with a proposed price change. You conduct a survey and find that if the price of a six-pack increases from $5.50 to $7.50, the quantity demanded will decrease from 2,200 units to 1,800 units a month. Should the Micro Brewing Corporation raise its price? Explain the economic basis for this recommendation to the president.

Yes, the corporation should increase the price of a six-pack. Over the price range considered, the price elasticity of demand coefficient is 0.65, or inelastic, using the midpoints formula. An increase in price when demand is inelastic will increase total revenue. This increase in total revenue also can be shown by multiplication. With a price of $5.50 times a quantity of 2,200 per month, the total revenue was $12,100. With the higher price of $7.50 times a lower quantity of 1,800, the total revenue is $13,500. Thus, there is a gain of $1,400 in total revenue from raising the price. [text: E pp. 376-380; MI pp. 118-122]

426


12. Based on the determinants of elasticity as discussed in the text, explain what the price elasticity of demand of the following products would be: (a) ballpoint pens; (b) Crest toothpaste; (c) diamond rings; (d) sugar; and (e) refrigerators.

(a) Ballpoint pens: Demand should be slightly elastic because there are substitutes, and they are not a complete necessity. However, they are not very durable and the price is small relative to most incomes, and the substitutes are not quite the same so the elasticity will not be high.(b) Crest toothpaste: Demand should be very elastic because there are very many other brand-name substitutes, and this brand is not a necessity.(c) Diamond rings: Demand should be elastic because there are other types of rings, the price is high relative to most incomes, they are durable, and they are a luxury item.(d) Sugar: Demand should be inelastic because there are few close substitutes, the price is small relative to most incomes, it is not a durable good, and not usually viewed as a luxury.(e) Refrigerators: Demand is probably somewhat elastic because the price is large relative to most incomes and they are durable so an old refrigerator can last until “the price is right.” However, refrigerators are not luxuries and there are no good substitutes, so the demand is probably not very elastic with respect to price. [text: E pp. 380-381; MI pp. 380-381]

14. Federal and state governments often seek to raise tax revenue by levying excise or sales taxes on specific products. What economic factors should be considered in determining the products that will raise the most tax revenue? Give examples of products in your answer.

Government officials should consider taxing products for which the price elasticity of demand is inelastic. Liquor, gasoline, and cigarettes are examples of goods with inelastic demand on which tax increases are imposed to raise tax revenue. When a product has an inelastic demand, an increase in taxes will increase total spending on the product and hence the revenue collected by government. There will be a negative effect on the quantity consumed, and thus employment in the industry, but the employment effects will be less harmful than if the product taxed was elastic. Taxing a product for which the demand is relatively elastic is likely to reduce tax revenue from the product and reduce significantly employment in the industry. Such a situation arose in 1991 when the U.S. Congress imposed a luxury tax on yachts costing more than $100,000. Congress thought that the demand for yachts was relatively inelastic, but it proved to be more elastic than originally thought. Employment in the boating industry fell significantly and the tax produced minimal revenue for government. [text: E p. 382; MI p. 124]

15. Explain the perspective that tougher enforcement of drug laws for cocaine or other drug laws may actually increase the crime rate. Use the concepts of demand, supply, and elasticity in your explanation.

Tougher enforcement of drug laws reduces the supply of cocaine and other illegal drugs, thus driving up the street price. The demand for cocaine and other drugs, however, appears to be highly inelastic. The increased price will increase total revenues and profits for sellers, but at the same time it will increase total spending by drug users. To support this increased spending, drug users are likely to commit more crimes. Thus, the increased enforcement of drug laws may have the secondary effect of increasing money-producing crimes such as robbery, burglary, shoplifting, and fraud. [text: E p. 382; MI p. 124]

16. Discuss the pros and cons of legalizing drugs such as heroin or cocaine from an economic perspective using the concepts of supply, demand, and elasticity.

427


The pro side for legalization looks at the price elasticity of demand for heroin and cocaine. This demand is price-inelastic which means that if the price of these drugs was reduced, there would be less spent on them by users. Legalization of these drugs will tend to increase the supply and reduce the price. The reduced price will reduce the total expenditures on these drugs. Fewer users will have to resort to crime to pay for the drugs and there would be less need for law-enforcement resources used for the “war on drugs.”

The opponents of legalization suggest that there are two types of consumers of illegal drugs — addicts and occasional users. The demand from addicts is price-inelastic as discussed above. The demand by the occasional users, however, is more price-elastic. As price falls, this type of user will spend more on these drugs. This additional consumption in turn may cause some of the occasional users to become addicts. The greater social acceptability for the use of such drugs may also increase the demand for these drugs, which would increase consumption, stimulate more addiction, and increase crime in the long run. The additional social cost from these developments would be much greater than any benefit from simple reduction of expenditures by addicts and short-term reduction in law-enforcement costs. [text: E p. 382; MI p. 124]

22. Why would it be valuable for a business to know the cross elasticity of demand for the two products it produces: peanuts and popcorn?

The cross price elasticity of demand shows the responsiveness of the quantity demanded for one product to a change in the price of another product. The business can use this concept to determine whether there is a substitute, complementary, or independent relationship between peanuts and popcorn. If peanuts and popcorn are substitutes, a rise in the price of peanuts will cause an increase in the quantity demanded for popcorn (the cross elasticity will be positive). On the other hand, if peanuts and popcorn are complementary goods, a rise in the price of peanuts will decrease the quantity demanded for popcorn (the cross elasticity will be negative). The business will want to know the nature of the relationship between the two products and how responsive the quantity demanded for one product is to a change in the price of the other before a price is changed. This cross elasticity information will be useful for increasing total revenue and profits. [text: E p. 385; MI p. 127]

28. What is a price ceiling and what are its economic effects?

A price ceiling means that the price is not allowed to rise above the maximum price set by government. If the price ceiling is set below the equilibrium price in a market, then there will be a shortage of the product at the government-set price. A price ceiling interferes with the rationing function of price that serves to balance the decisions of suppliers and demanders. The shortage indicates that resources are being underallocated to the production of this product and that there is economic inefficiency. Less output is being produced than consumers want. This output is not being produced because some producers cannot make a profit at the price ceiling level. [text: E pp. 386-387; MI pp. 128-129]

30. What is a price floor and what are its economic effects?

A price floor means that the price is not allowed to fall below a minimum price set by government. If the price floor is set above the equilibrium price in a market, then there will a surplus of the product. A price floor interferes with the rationing function of price that serves to balance the decisions of suppliers and demanders. The surplus indicates that resources are being overallocated to the production of this product and that there is

428


economic inefficiency; output is being produced which consumers do not want to purchase at the price floor. [text: E pp. 388-389; MI pp. 130-131]

33. (Last Word) Use economic analysis to explain why tenants in New York City who are covered by rent-controlled laws do not want to move even when they are offered a large buyout.

The tenants obtain the rights to the apartment at the rent-controlled price long ago. The rent-controlled price is far below the market price for such an apartment. If they move out, they will have to pay market rates for an apartment that can be thousands of dollars higher per month. Over a period of years, that value of lower price is substantial. So, even when one woman was offered $250,000 as a buyout, she did not accept it because the benefits of living in such an apartment at the price of only $8 per day was much greater than her opportunity cost (giving up the $250,000 buyout). [text: E p. 390; MI p. 132]


2. What are two related effects that combine to make a consumer able and willing to buy more of a specific product at a lower price than a higher price? Explain the logic of both effects.

The two effects are the income and substitution effect. For most products, a price decrease gives consumers more income to spend on that product and other products, so the quantity demanded for that product increases. There are three steps in the logic for a typical product: The price falls, which gives the consumer more income to spend on that product and other products, thus increasing the quantity demanded for that product. A price decrease also makes the product a more attractive buy relative to its substitutes. Consumers will now purchase more of the relatively cheaper product instead of the now more expensive substitutes, thus increasing the quantity demanded of the product. With both effects, the end result is the same: the quantity demanded of the product increases as its price decreases. [text: E pp. 394-395; MI pp. 136-137]

4. Assume that a person only purchases two goods, food and clothing, and has a fixed budget constraint. Both goods are normal goods. If the price of food decreases, what will happen to the consumption of clothing based on the income effect?

The price decrease means that the real income of the person has increased. This income effect will give the person more money to spend on both food and clothing. The consumption of clothing will increase due to this income effect. [text: E pp. 394-395; MI pp. 136-137]

5. In a typical month, a family buys six bags of candy bars as snacks when the price of a bag costs $4.00. When the price of the candy bars falls to $3.00 a bag, the family buys seven bags of candy bars a month. When the price of a bag of candy bars rises to $6.00, the family buys three bags a month. Answer these questions: (a) How did the fall in the price affect real income in terms of bags of candy bars? (b) How did the rise in the price affect real income in terms of bags of candy bars? [Hint: How many bags of candy bars could the family buy in situation (a) and in situation (b) without changing the amount they spend on candy bars in a typical month?]

In the typical month, the family spends $24.00 on bags of candy bars ($4.00 x 6 bags). (a) When the price of a bag falls to $3.00 a bag that means real income measured in terms of bags of candy bars has increased by 2 bags because the family can now afford to buy 8 bags instead of 6 with the $24.00 they typically spent on candy bars. However, they decide to purchase only 7 bags ($3.00 x 7 = $21.00), so the other $3.00 can be

429


spent on other goods. (b) When the price rises to $6.00 a bag, that means that real income measured in terms of candy bars has fallen by 2 bags because the family can now afford to buy only 4 bags instead of 6 with the $24.00 typically spent on candy bars. [text: E pp. 394-395; MI pp. 136-137]

6. What is the difference between marginal and total utility?

Marginal utility is the additional satisfaction received from consuming one more unit of a product. Total utility is the overall or total satisfaction received from consuming some particular amount of the product. Total utility can be determined by summing the marginal utility for each unit of a product that is consumed. [text: E pp. 395-397; MI pp. 137-139]

7. Can marginal utility be negative? Briefly explain with an example.

Yes. The consumption of an additional unit of a product may be unpleasant. Consider a person who likes pizza. The first four slices of a large pizza taste great. Each slice gives the consumer additional satisfaction, although the amount of satisfaction diminishes with the consumption of each slice. Finally, the consumer eats the fifth slice of pizza and develops a stomachache from overeating. That fifth slice had negative marginal utility for this pizza consumer. [text: E pp. 395-397; MI pp.137-139]

8. Describe the law of diminishing marginal utility. On what assumptions is this law based?

The law of diminishing marginal utility means that as the consumer obtains more units of a given good or service, the consumer receives increasing amounts of total utility or satisfaction. However, the more units of the item that the consumer obtains, the less additional satisfaction or utility each successive unit of the good or service will provide. Total utility increases but by diminishing amounts.

The law assumes that more is preferred to less; that is, more units of a consumer good or service will bring more total utility. But the law also assumes that consumer satisfaction from the first unit obtained is greater than that for successive units. In other words, the intensity of the want or need declines as it is gradually more and more satisfied. [text: E pp. 395-397; MI pp. 137-139]

New 10. Describe how diminishing marginal utility is related to price elasticity of demand.

According the law of diminishing marginal utility, successive units of a product yield smaller and smaller amounts of marginal utility. The consumer will buy more of a product only if its price falls because otherwise it is not worth buying more. If marginal utility falls sharply as successive units are consumed, demand is predicted to be inelastic. That is, price must fall a relatively large amount before consumers will buy more of the product. If marginal utility falls slowly as successive units are consumed, demand is predicted to be elastic. That is, price must fall only a relatively small amount before consumers will buy more of the product. [text: E: p. 397; MI: p.139]

13. Assume that a consumer purchases a combination of products A and B. The MUa is 5 and the Pa is $5. The MUb is 6 and the Pb is $6. What should this consumer do to maximize utility?

The MUa/Pa = 1. The MUb/Pb = 1. The consumer is maximizing utility and should make no changes in consumption patterns. The marginal utility per dollar is the same for both products. [text: E pp. 398-400; MI pp. 140-142]

430


14. Assume that a consumer purchases a combination of products Y and Z. The MUy is 50 and the Py is $25. The MUz is 20 and the Pz is $5. What should this consumer do to

maximize utility?

The MUy/Py = 2. The MUz/Pz = 4. The consumer should consume more of product Z and less of product Y until the marginal utility per dollar is the same for both products. [text: E pp. 398-400; MI pp. 140-142]

New 18. How can the utility-maximizing rule be used to explain the substitution and income effect?

According the utility-maximizing rule, when the price of a product decreases, the consumer will no longer be in equilibrium. Equilibrium will only be restored when more of the product is purchased and the marginal utility of the product decreases to match the decline in price. The consumer will purchase or substitute this now cheaper product for the relatively more expensive substitute. The income effect is shown by the fact that a decrease in price increases the real income of the consumer. Thus, the consumer can purchase more of this product and other products until equilibrium is achieved for the new level of real income. [text: E: pp. 401-402; MI: pp. 143-144]

19. A vice president of a company argues that the president of the company should raise workers’ wages if the president wants less absenteeism. The president says that wages probably should be cut so that the workers could not afford to miss so much work. Evaluate the two views using the income and substitution effects in your analysis.

The analysis must be based on the idea that most workers prefer leisure to working for the president of the company. Therefore, the higher their income, the more leisure they can afford (income effect). On the other hand, the higher their wage, the more costly it will be to give up an hour of work, and the less leisure “time-off” they will substitute for work (substitution effect). The income and substitution effects tend to work in opposite directions.

If the income effect outweighs the substitution effect, then the vice president is wrong. Paying the workers more will enable them to work shorter hours and earn enough to afford their added leisure despite the partly offsetting effect of the substitution effect that has made leisure more expensive per hour.

If the substitution effect outweighs the income effect, then the vice president is right and the president is wrong. Paying the workers less will cause them to work fewer hours because they don’t lose as much for each hour not worked. The effect of the lower income will partially offset the lower price of leisure, but not enough to cut the rate of absenteeism. In fact, absenteeism may increase.

Either could be correct. The solution depends on the strength of the income and substitution effects for the workers, and that, in turn, depends on many factors such as their present income status, the opportunities for using one’s leisure time, and so on. [text: E pp. 394-395; MI pp. 136-137]

21. Why would an ounce of gold be priced higher than an ounce of coffee beans, even though coffee is generally considered more essential than gold? Explain the paradox in terms of marginal and total utility.

The basic reason is that the gold is relatively scarce, and it has a high price. Coffee is relatively abundant, and has a low price. The utility-maximizing rule indicates that consumers should continue purchasing any product until the ratio of its marginal utility

431


to its price is equal to that for all other products. Gold must have a high marginal utility and price, while coffee must have a low marginal utility and price for consumers to maximize utility. Consumers, however, generally purchase only small quantities of gold because of the high price, and large quantities of coffee because of the low price. Coffee is considered to be more essential than gold, even though its price is lower, because the total utility from consuming coffee (sum of the marginal utilities) is much greater than the total utility from consuming gold. [text: E p. 402; MI p. 144]

23. How does the pricing of medical care in the United States affect the quantity consumed?

Health insurance pays most of the cost of medical care for individuals. Most individuals with health care coverage wind up paying only 20-30 percent of the full cost of such care. Thus, the price of medical care to the individual consumer comes at a significant discount. This “lower” price for the consumer encourages them to consume more medical care than they otherwise would if they paid the full cost for treatment. [text E pp. 403-404; MI pp. 145-146]


1. Why are costs important in economics? Why don’t economists use the same cost data as accountants use?

Costs are important in economics in determining the allocation of resources based on what firms are willing to pay, which in turn depends on how much consumers are willing to pay for the products produced by these resources. Costs reflect the market prices of the resources used in production, but also economic costs include the opportunity cost of using some resources that may not have an explicit market price. Economists argue that the cost of all resources should be considered when determining the real cost of production.

Implicit costs are as important as the explicit costs which are generally the so-called “accounting costs.” For example, economists (but not accountants) would count the income forgone in the use of the owner’s time as an economic cost, the interest forgone by using one’s own funds, and so on. These implicit costs should be counted so one can judge the true economic or opportunity cost of production. If these costs are neglected, then an overallocation of resources could occur because not all of the production costs are being measured. [text: E pp. 415-417; MI pp. 157-159]

4. Jane quit her job at AT&T where she earned $29,000 a year. She cashed in $40,000 in corporate bonds that earned 10% interest annually to buy a mini-bus. Jane has decided to buy the mini-bus and set up a commuter service between Lincoln and Omaha. There are 1000 people who will pay $400 a year each for the commuter service; $280 from each person goes for gas, maintenance, insurance, depreciation, etc.

(a) Complete the following questions: (1) What are Jane’s total revenues? (2) What are Jane’s explicit costs? (3) What is her accounting profit?(b) List two important implicit costs that Jane has not included.(c) What is Jane’s pure economic profit (loss)?(a) (1) Total revenues are $400,000. (2) Explicit costs are $280,000. (3) The accounting profit is $120,000.(b) (1) Salary that could be earned at AT&T ($29,000). (2) Interest on invested savings ($40,000 x 10% = $4,000). Total implicit costs are $33,000.(c) Economic profit is $87,000. [$400,000 – ($280,000 + $33,000) = $87,000]. [text: E pp. 415-417; MI pp. 157-159]

5. Why is the distinction between fixed and variable cost important?

432


The importance in distinguishing between fixed and variable costs will become more apparent in later chapters when the firm’s decision about price and output determination is examined. For now, the primary importance has to do with the distinction between the long run and the short run. Once fixed costs are incurred, a short-run period has been determined by the length of time that those costs are fixed, i.e., cannot be varied. The firm has no immediate control over these costs. Other costs that vary with the level of output then are variable costs. Later we will learn that they are important in determining the profit-maximizing or loss-minimizing level of output given the plant size and other fixed costs. [text: E p. 417; MI p. 159]

6. Indicate whether the inputs below are variable (V) or fixed (F) in the short run.

Input Output V Meat in hamburgers. F Fire insurance in dry cleaning. V Tires in automobiles. F Property tax in textile production. V Gasoline in trucking services. F Depreciation in aircraft production.

[text: E p. 417; MI p. 159]

7. What is the difference between the short run and the long run?

The short run is a period too brief for a firm to alter its plant capacity, but it can still change the degree to which the fixed plant is used. The long run is a period in which the firm can change all resources including the size and number of plants. It is often stated that the short run is a “fixed-plant” period and the long run is a “variable plant” period. [text: E p. 417; MI p. 159]

New 9. What is the relationship between total product, marginal product, and average product shown by the law of diminishing returns?

Total product first increases at an increasing rate, but then it increases at decreasing rate. After it reaches a maximum, it then declines. The marginal product shows the slope of the total product curve. When total product is rising at an increasing rate, marginal product is rising. When total product is increasing at a decreasing rate, then marginal product is still positive, but diminishing. When total product reaches a maximum, marginal product is zero. Total product declines when the marginal product becomes negative. The average product has similar characteristics to marginal product. It rises, reaches a maximum, and then declines. In the rising phase for average product, marginal product is greater than average product. Average product declines at the point at which the marginal product falls below average product. [text: E pp. 419-420; MI pp. 161-162]

11. What is the law of diminishing returns? Give a descriptive example.

The law states that as additional units of a variable resource such as labor are added to a fixed resource such as capital, beyond some point the additional, or marginal, product attributable to each additional unit of the variable resource will decline. An example would be a factory assembly line. The capital (assembly line) is fixed. As more and more workers (variable inputs) are assigned to work on the assembly line, the output produced by each additional worker is likely to decline at some point. The reasons for this decline are that the assembly line equipment may be fully utilized and beyond some point of production additional workers would only cause problems for the existing

433


workers. Productivity, output per work hour, would fall as more workers are added. [text: E pp. 417-421; MI pp. 159-163]

15. What is the relationship between marginal cost and marginal product?

Marginal cost is the change in total cost divided by the change in output. Marginal product is the change in output divided by the change in input. Assume that each additional unit of a resource is hired at a constant price, or that the change in total cost is constant. If input changes by 1 unit, then marginal product is simply the change in output. Thus, marginal cost is simply a constant change in total cost divided by marginal product. As marginal product increases, marginal costs decline. As marginal product decreases, marginal costs increase. This increasing and decreasing relationship for marginal product is suggested by the law of diminishing returns. [text: E p. 425; MI p. 167]

16. Why does the short-run marginal-cost curve eventually increase for the typical firm?

The shape of the firm’s marginal cost curve is a result of the law of diminishing returns. If all units of a variable resource are hired at the same price, the marginal cost of each additional unit of output will fall as long as the marginal product of each additional resource is rising. Marginal cost is equal to the marginal product of each additional unit of resource divided by the constant cost of each additional unit. As diminishing returns set in, the marginal product of each additional resource falls and when divided by the constant price for each unit of resource, the marginal cost will now rise. [text: E pp. 425-426; MI pp. 167-168]

23. Answer the questions below on the basis of the diagram.

(a) How can you tell if these cost curves are for the short run or the long run?

(b) What does the graph indicate about:(1) AVC at 6,000 units of output?(2) ATC at 6,000 units of output?(3) AFC at 6,000 units of output?(4) TVC at 6,000 units of output?(5) TFC at all levels of output?(6) TC at 10,000 units of output?(7) When diminishing returns set in?

(a) The ATC, AVC, and MC curves are for one size of plant. In the short run, there are fixed costs and variable costs. In the long run, all costs are variable.(b) (1) AVC at 6,000 units is $4.00.

434


(2) ATC at 6,000 units is $5.50.(3) AFC at 6,000 units is $1.50.(4) TVC at 6,000 units is $24,000 ($4.00 x 6,000).(5) TFC at all levels of output is $9,000.(6) TC at 6,000 units is $90,000.(7) Diminishing marginal returns set in at 3,000 units.

[text: E pp. 421-426; MI pp. 163-168]

25. What effect would each of the following have on the short-run average and marginal costs of an auto dealership: (a) auto mechanics receive a 10% wage increase; (b) property taxes decrease; (c) auto dealers institute a one-time only promotional campaign?

(a) The increase in wages raises variable costs. AVC, ATC, and MC will rise.(b) Property taxes are viewed as fixed costs that must be paid irrespective of output level. AFC and ATC will fall.(c) Advertising campaigns are a one-time expense considered to be fixed costs. AFC and ATC rise. [text: E pp. 425-426; MI pp. 167-168]

27. What factors explain economies of scale?

First, as plant size increases, there can be greater specialization of labor that permits increased productivity and lower average costs. Second, managerial specialization can occur as plant size increases and contributes to increased productivity and lower costs. Third, larger-scale firms are usually able to make use of more efficient (technologically superior) capital equipment that may only be suitable for use if there is a large quantity of production. Fourth, some enterprises require large start-up costs that can be reduced as output increases. [text: E pp. 429-431; MI pp. 171-173]

29. Consider the diagram below. Curves 1–8 are the short-run curves that occur with different plant sizes. Answer the next two questions.

(a) On the graph show the range of outputs for: (1) economies of scale; (2) diseconomies of scale: Indicate (3) minimum efficient scale.(b) In the long run, what plant size should the firm build if it wants to produce: (1) 6000 units; (2) 14,000 units?

(a) Answers given in graph below.

(b) (1) Plant size 3 would be used to produce 6,000 units; (2) plant size 6 would be used to produce 14,000 units. [text: E pp. 427-428; MI pp. 169-170]

New 33. (Last Word) What is the economic meaning of the saying “Don’t cry over spilt milk” and its implications for economic decision-making?

435


The saying “Don’t cry over spilt milk” is another way of saying that sunk costs (the milk in this case) are irrelevant to current decision-making and should be forgotten. The milk has already been spilt and cannot be recovered, so ignore that cost and go on from there. Do not let the spilt milk, or sunk cost, affect your current decision-making. The reason for this view is that economic analysis says that you should take actions for which the marginal benefits are greater than the marginal costs. Sunk costs, however, are past costs that should be ignored and not added to marginal cost when making a current decision. Suppose you purchased an expensive ticket to a football game and you are sick the day of the game. The price of the ticket is a sunk cost paid when the ticket decision was made and should not enter into your attendance decision. In general, a prior decision and its cost should not dictate or influence a second decision. If a cost has been incurred and cannot be partly or fully recouped by some other choice, it should be ignored by a rational consumer or producer. [text: E pp. 433; MI pp. 175]


2. What are some examples of the four different market structures?

Examples of pure competition can be found in the market for agricultural products and in financial markets. Retail stores and restaurants provide examples of monopolistic competition. Standardized oligopolies would be found in the production of aluminum, steel, copper, and other metal products. Differentiated oligopolies would be found producing automobiles and large household appliances such as refrigerators. Pure monopoly would be exemplified by local utilities such as electric, gas, or phone companies. [text: E p. 438; MI p. 180]

3. What are four characteristics of pure competition?

The four are: (1) the presence of a large number of sellers that act independently in a market; (2) the production and sale of a standardized or homogeneous product; (3) the individual firms are “price takers” in the sense that the seller must accept the going market price for the sale of output; and (4) new firms can easily enter the market and existing firms can easily exit the market. [text: E pp. 438-439; MI pp. 180-181]

4. How would you describe the demand curve for the purely competitive firm? For the industry?

The demand curve for the individual competitive firm is perfectly elastic. The firm can sell all the output it can produce at the competitive market price because each firm accounts for only a negligible share of the market. There is no reason for the firm to lower price to sell more, nor can the firm obtain a higher price by restricting output. The market or industry demand curve, however, is downsloping. Consumers will only purchase greater output for the entire industry at a lower price, but less output can be sold to consumers at a higher price. [text: E pp. 439-440; MI pp. 181-182]

5. What is the difference between average, total, and marginal revenue? What is the shape of the total and marginal revenue curves for the individual competitive firm?

Average revenue is the amount of money the firm receives per unit of sale. Total revenue is the market price times the quantity that the firm can sell. Marginal revenue is the change in total revenue from selling one more unit of output. The marginal revenue curve for the individual competitive firm is a horizontal straight line because there is a constant change in total revenue from selling one more unit of output. The total revenue curve is an upsloping straight line. Market price is constant and multiplied by an increasing amount of quantity sold. [text: E pp. 439-440; MI pp. 181-182]

436


6. Why does price equal marginal revenue for the purely competitive firm? What is the relationship to the demand curve for the firm?

The purely competitive firm is a “price-taker” in the market. The price it receives for its output is constant and does not vary across its range of output. Marginal revenue is defined as the change in total revenue from selling one more unit of output. One more unit of output will be sold at a constant, market-determined price. Thus, price will be equal to the marginal revenue for the firm. Also, the firm’s demand curve will be perfectly elastic because no matter how much or how little the firm produces it will receive the same price per unit of output. Thus, demand equals price and marginal revenue. [text: E pp. 439-440; MI pp. 181-182]

9. What conditions are necessary to determine if the purely competitive firm should produce in the short run? State the marginal revenue and marginal cost conditions and the total revenue and total cost conditions.

From TC-TR perspective, the firm should produce if TR exceeds TC, or if TC exceeds TR by some amount less than total fixed cost. From an MC-MR perspective, the firm should produce if price is equal to, or greater than, the minimum average variable cost. [text: E pp. 441-447, 451; MI pp. 183-189, 193]

10. What quantity should the purely competitive firm produce to maximize profits? Analyze from a total revenue and total cost perspective and a marginal revenue and marginal cost perspective.

From an MC-MR perspective, the firm should produce where MR or price equals MC. From a TC-TR perspective, the firm should produce where the excess of TR over TC is a maximum or where the excess of TC over TR is a minimum (and less than total fixed costs). [text: E pp. 441-447, 451; MI pp. 183-189, 193]

14. An airline is flying between two cities. The airline has the following costs associated with the flight:

Crew $4,000 Plane daily depreciation $2,000Fuel 1,000 Plane daily insurance 2,000Landing fee 1,000

The airline has an average of 40 passengers paying an average of $200 for this flight. Do you think the airline should be flying between the two cities? Evaluate from a short-run and long-run perspective.

Yes, from a short-run perspective, the airline should make this flight between the two cities. The total variable costs are $6,000 ($4,000 + $1,000 + $1,000). The total revenue is $8,000. Thus the flight covers total variable cost and leaves $2,000 to apply against $4,000 of total fixed cost. If the plane did not fly, the firm would lose the entire $4,000 of total fixed cost.

The average variable costs are $150 per passenger ($6,000/40 passengers). The price, or average revenue of $200 is greater than the average variable cost of $150. The airline received enough revenue to cover average variable costs and also $50 per passenger to offset fixed costs that average $100.

No, from a long-run perspective. The price of $200 is less than ATC of $250 ($10,000/40). The airline is losing $50 per passenger, or $2,000 per flight and cannot afford to take this loss on each flight in the long run. [text: E pp. 442-447, 451; MI pp. 184-189, 193]

437


15. What is the relationship between marginal cost and the supply curve for the purely competitive firm?

There are several relationships between marginal cost and the supply curve for the purely competitive firm. First, the short-run supply curve for the purely competitive firm is the portion of the marginal cost curve that lies above average variable cost. Second, there are links between the law of diminishing returns, production costs, and product supply. The law of diminishing returns suggests that marginal costs will increase as output expands. The firm must receive more revenue (get higher prices for its product) if it expands output. If marginal revenue is greater than marginal cost, the firm has an incentive to expand production because it adds to the firm’s profits. Third, changes in variable inputs will change the marginal cost or supply curve for the purely competitive firm. For example, an improvement in technology that increases productivity will decrease the marginal cost curve (shift it downward), thus increasing the supply curve for the firm. Given a fixed marginal revenue, output will expand until marginal cost equals marginal revenue under the new conditions. [text: E pp. 447-448; MI pp. 189-190]

17. How will the marginal and average cost curves of the typical pure competitor shift or change as a result of the following events: (a) an increase in wages of all labor; (b) an increase in the rental payments on office machinery; (c) a technological advance; (d) an increase in sales taxes; (e) an increase in property taxes; and (f) a decline in the price of

a basic raw material?

(a) An increase in variable cost. AVC, ATC, and MC will shift upward.(b) It depends on whether or not the office machinery is fixed or variable. If fixed, it will shift AFC and ATC upward. If variable, it will shift AVC, ATC, and MC upward.(c) An increase in variable cost. Assuming no new fixed costs are incurred, this will shift AVC, ATC, and MC downward since it means labor is more productive.(d) An increase in variable cost. AVC, ATC, and MC will shift upward.(e) An increase in fixed cost. AFC and ATC will shift upward.(f) A decrease in variable cost. AVC, ATC, and MC will shift downward. [text: E pp. 447-449; MI pp. 189-191]

18. The agricultural market for corn can be characterized as a purely competitive industry. How might the following events affect the short-run cost curves and output for a firm in the industry?

(a) A reduction in the cost of fertilizer that is sold to corn farmers.

(b) The Internal Revenue Service (IRS) changes tax laws which increase the amount of depreciation that farmers can deduct for equipment.

438

MR


(c) The market price of corn falls.

(a) The fall in fertilizer costs will reduce variable costs for each firm. AVC, ATC, and MC will fall. Output will expand for each firm because the MC curve will shift to the right along the existing MR curve. MR or price or marginal revenue stays constant because the firm is a price taker in a purely competitive industry.(b) The tax law change affects depreciation. Depreciation is a fixed cost that must be paid irrespective of the level of output. Thus the fixed cost for farmers has decreased. This change means that AFC and ATC falls, but output stays the same and is set where MC = MR.(c) This change will lower MR but will not change the short-run cost curve. Output will fall because the lower MR or price will be equal to MC at a lower output level. [text: E pp. 447-449; MI pp. 189-191]

24. Consider the two diagrams below. Diagram A represents a typical firm in a purely competitive industry. Diagram B represents the supply and demand conditions in that industry.

(a) Describe the price, output, and profit situation for the individual firm in the short run.

(b) Describe what will happen to the individual firm and the industry in the long run. Show the changes on diagrams A and B.

(a) The firm will sell its output for a price of $4.00 per unit. It is making a profit because MR of $4.00 is greater than ATC.(b) In the long run, firms will enter the industry because existing firms are making economic profits. This increase in the number of firms will shift the supply curve for the industry to the right and lead to a decrease in the market price to $3.00. At this price, the individual firm will neither be making an economic profit nor taking an economic loss. It will be in equilibrium. See graphs above. [text: E pp. 449-453; MI pp. 191-195]

New 28. Describe the graph for a long-run supply curve in an increasing-cost industry. Why does it have this slope?

For the graph, quantity or output for the industry will be on the horizontal axis and price will be on the vertical axis. The slope of the graph for a long-run supply curve in an increasing-cost industry will be upsloping. It shows that shows that an increase in the level of output is associated with an increase in the price of the product. The reason for the upward slope is that as firms increase output, they bid up resource prices, and this

439


increases the minimum average total cost of the product. [text: E pp. 454-455; MI pp. 196-197]

30. What economic conditions are necessary to achieve productive and allocative efficiency under pure competition?

Productive efficiency requires that each good be produced in the least costly way. In the long run, competition forces firms to produce at the point of minimum average total cost and to charge a price which is just equal to those costs. Allocative efficiency means that resources are distributed among firms such that a mix of products is produced that is most desired by society. The price of any product is society’s measure of its perceived marginal benefit from consumption of the product. The marginal cost measures the relative value of the resources that were used to produce the product. Pure competition is allocatively efficient because P equals MC, or society’s perceived marginal benefit from the consumption of the product just equals the opportunity cost of the resources used to produce the product. [text: E pp. 455-457; MI pp. 197-199]

34. How does the “invisible hand” work in a competitive market system?

Businesses and resource suppliers seek to further their own self-interests. Businesses seek to maximize profits and in doing so they make efficient use of society’s scarce resources. Thus the competitive market system directs activity with an “ invisible hand” that promotes the social interest. Resources are allocated to their best use and the result produces the greatest amount of consumer satisfaction. [text: E p. 458; MI p. 200]


1. What are the major characteristics of pure monopoly?

A pure monopolist is the only seller of a product for which there are no close substitutes. To maintain this position as the sole seller of a unique product, there must be barriers to entry. Also, the monopolist has “price making” power because the monopolist is the industry and supplies the entire market for the product. Given a downsloping demand for the product, the monopolist must decrease price to increase quantity sold. Finally, advertising under pure monopoly often depends on the nature of the product and whether the monopolist feels there is a need to increase demand for the product. [text: E pp. 463-464; MI pp. 205-206]

2. What are the major barriers to entry that explain the existence of monopoly?

There are at least four types of entry barriers that create the conditions for pure monopoly. First, economies of scale means that in some industries large-scale production is necessary to achieve the most efficient level of production. In this case, the long-run average cost curve will tend to decline over a wide range of output for a product. Either a few firms, or in the extreme, one firm, will be necessary to provide market demand in the most efficient way. In the extreme, there are natural monopolies that arise when competition between firms is simply inefficient or impractical. The best examples of natural monopolies are public utilities, which are given the exclusive right by government to provide the utility services. Second, the government can restrict entry into a market by granting patents and licenses. A patent gives exclusive production rights to a firm for twenty years. Licenses limit entry into a business or an occupation. Third, pure monopoly arises when a firm has complete ownership of an essential resource, such as aluminum or copper. Fourth, there are pricing or strategic barriers to entry. [text: E pp. 464-466; MI pp. 206-208]

New 3. What is the relationship between economies of scale and a natural monopoly?

440


In those extreme cases where there are extensive economies of scale across the full range of potential output for market demand, it may be most economical for only one firm to supply the entire market. In this case one firm, rather than two or more firms, would have declining average costs across the entire range of market demand and be the lowest cost producer. The single firm would be characterized as a natural monopoly. [text: E pp. 464, 474; MI pp. 207; 216]

4. Some economists argue that pure monopolists will purposely avoid the price-output combination that will maximize their profits. Explain how this less-than-maximum profit behavior could be rational.

A pure monopoly may fear the threat of competition and keep prices and profits intentionally low to avoid attracting other firms into the market, or it may increase its expenditures to maintain the barriers to entry. Either action decreases profits below the maximum possible. Also, the monopoly may wish to avoid any government intervention (or more government intervention), and by avoiding high economic profits, it may not call attention to its real monopoly power. [text: E pp. 466, 474-475; MI pp. 208, 216-217]

6. Why is marginal revenue less than price for every level of output except the first?

The monopolist is the industry, so its demand curve slopes downward. To increase sales, the monopolist must lower price. The price decreases apply not to the additional quantity sold, but also to all other units of output which otherwise would have been sold at a higher price. As each extra unit of output is sold, it will contribute to total revenue its price less the sum of the price decreases that apply to all prior units of output sold. [text: E pp. 467-468; MI pp. 209-210]

8. A pure monopolist determines that at the current level of output the marginal cost of production is $2.00, average variable costs are $2.75, and average total costs are $2.95. The marginal revenue is $2.75. What would you recommend that the monopolist do to maximize profits?

Marginal revenue is greater than marginal cost at the current level of output. The monopolist should increase output to where marginal costs equal marginal revenue. [text: E pp. 469-471; MI pp. 211-213]

9. A pure monopolist sells output for $4.00 per unit at the current level of production. At this level of output, the marginal cost is $3.00, average variable costs are $3.75, and average total costs are $4.25. The marginal revenue is $3.00. What is the short-run condition for the monopolist and what output changes would you recommend?

The monopolist should make no change in the level of output because the marginal costs equal the marginal revenue at the current level of output. However, the monopolist is experiencing short-run losses because average total cost is greater than the price (average revenue). In the long run, the monopolist may want to try to shift the demand curve so that price is greater than average total cost at the current level of production. The monopolist may also want to find ways to reduce average costs. [text: E pp. 469-471; MI pp. 211-213]

14. Do you agree or disagree with the statement that: “A monopolist always charges the highest possible price.” Explain.

Disagree. The pure monopolist has a downsloping demand curve for the product. If the monopolist charged the highest price, the monopolist would only sell one unit or no

441


units of the product. The monopolist, however, is concerned with maximizing profits, not with charging the highest price. A lower price would produce more revenue relative to cost. The monopolist will charge the price where the additional revenue from the sale of another unit just equals the additional cost of the additional units, or where MR = MC. The monopolist will set price somewhere in the elastic portion of the demand curve where marginal revenue is positive but less than price. [text: E p. 471; MI p. 213]

15. “Pure monopoly guarantees economic profits.” Discuss whether this is a valid statement.

The statement is not always valid. A pure monopolist has a greater likelihood of earning economic profits, but the monopoly position does not guarantee profits. There can be weak demand for a monopoly product that results in the monopolist price being less than average total costs at the profit-maximizing level of output. This situation results in economic losses for the monopolist. [text: E p. 472; MI p. 214]

16. How does monopoly compare with pure competition in terms of price, output, and efficiency?

Given the same costs of production, a monopolist will charge a higher price and produce less output than a purely competitive firm or industry. The result in monopoly is an underallocation of resources to the production of the product. Society would prefer more output. [text: E pp. 472-473; MI pp. 214-215]

17. Explain how monopoly causes an inefficient allocation of resources when the competitive firm does not, even when both seek to maximize profits.

Both monopolies and competitive firms will maximize profits where marginal revenue equals marginal cost. The difference is that in a competitive environment, marginal revenue is the same as the price. Therefore, price is equal to marginal cost and in the long run this will be at the minimum average cost level. This means that there are no economic profits, and there is allocative efficiency because consumers are paying a price equal to the marginal cost of the last product produced. Also, productive efficiency exists because P = minimum ATC.

However, the monopoly finds its marginal revenue is below the price it can obtain at each output level. This occurs because the monopolist faces a downsloping market demand curve, and to sell larger output, it must lower the price. Since the price is lowered on all units of output, the gain in total revenue is less than the price for each additional unit produced. That is, the marginal revenue is below the price. When a monopoly finds the output level where marginal revenue equals marginal cost, it then finds that it can sell that level of output at a price that exceeds the marginal revenue. Therefore, the consumer is paying a price that exceeds the marginal cost of production. This means allocative efficiency is not achieved. If the price were allowed to fall to the marginal cost, the consumer would purchase a greater quantity at a lower price. Therefore, the monopoly situation is not efficient from the economic point of view. Specifically, there is an underallocation of resources (P > MC). Also, production does not occur at minimum average total cost so productive efficiency is not realized. There is also the possibility that a lack of competitive pressure will cause the monopolist to be less efficient in its production methods (x-inefficiency), so monopoly may not be as efficient in the production sense as is the competitive firm. [text: E pp. 473-474; MI pp. 215-216]

24. What are three policy options for dealing with pure monopolies that are entrenched and inefficient?

442


First, government can break up the monopoly into competing firms through the use of antitrust laws. Second, government can regulate the monopoly. In this latter case, the monopoly firm is permitted to exist, but its price and output decisions are subject to public scrutiny through regulation. Third, the government may do nothing if the monopoly is short-lived. [text: E pp. 476-477; MI pp. 218-219]

25. Price discrimination is often used by businesses. Explain the conditions under which price discrimination is practiced and the economic consequences of price discrimination.

Three conditions make price discrimination possible. First, the seller must be a monopolist, or possess some degree of power to control the price of the product. Second, the seller must be able to segment the buyers of the product into different groups that reflect differing willingness to pay for the product. Third, the buyers who have the opportunity to purchase at a lower price cannot resell the product to the buyers who must purchase the product at a higher price.

The consequences of price discrimination are twofold. The seller practicing price discrimination will be able to increase profits because the seller will be able to extract more revenue from buyers, and given the same cost structure, will be able to make more profit. Also, the price discriminating seller will tend to produce more output than the nonprice discriminating seller. [text: E pp. 477-479; MI pp. 219-221]

28. What are the consequences of price discrimination for the producer, the consumer, and for society?

Price discrimination can yield additional profit for the pure monopolists. By segmenting the market, the pure monopolist can charge a higher price to those who are willing to pay more for a product. Total revenue and profits are increased as a consequence. A discriminating monopolist will also produce more output than a nondiscriminating monopolist. When a discriminating monopolist lowers the price, the reduced price is only for the additional units sold and not for prior units sold. Total revenue can increase as output increases beyond what would be the case if there were no price discrimination and thus the firm will find it more profitable to increase output. From society’s perspective, this increased output makes the pure monopolist less allocatively inefficient than would be the case if there were no price discrimination. [text: E pp. 478-479; MI pp. 220-221]

29. What is the dilemma of regulation in the case of a regulated monopoly?

When price is set equal to marginal cost to achieve the most efficient allocation of resources there will be a lower price and greater level of output. The regulated monopoly, however, is likely to realize an economic loss with this socially optimal price and require a subsidy from government. In contrast, a “fair-return” price where price equals average cost produces no profits or losses for the regulated monopolist, but results in less output and a higher price than under the socially optimal price. The regulatory body must make a decision about whether to subsidize a monopolist charging the socially optimal price, or accept less output or underallocation of resources and a higher price that results from the fair-return pricing policy. [text: E pp. 479-481; MI pp. 221-223]

New 33. (Last Word) What was the power of the De Beers diamond monopoly? What supply and demand factors have affected it in recent years?

De Beers produces about 50 percent of all rough-cut diamonds in the world and buys for resale many of the diamonds produced elsewhere. It markets about 63 percent of the world’s diamonds. Its past price and output behavior fit the monopoly model. It sells a

443


limited quantity of diamonds, which will yield an “appropriate” monopoly price that is well over production costs. The firm earned monopoly profit.

Several supply factors have undercut the monopoly power of De Beers. New diamond discovers increased the supply of diamonds on the market that were not under the firm’s control. Other firms have withdrawn from an arrangement in which they sold their diamonds to De Beers and these firms now market their diamonds on their own. De Beers was also concerned about possible boycotts from their buying diamonds in war-torn regions of Africa, and thus they would be accused of indirectly financing the conflicts. These diamond-producing areas were no longer under De Beers control. The company has responded to the problem of no longer being able to control diamond supply as a monopolist by putting more emphasis on the demand for its diamonds through advertising, which in effect creates an increased demand for De Beers diamonds over other diamonds. De Beers can also still manipulate supply to a certain extent because it still has control over a large share of diamonds produced and marketed. [text: E p. 482; MI p. 224]


1. What are the major features of monopolistic competition compared to pure competition and pure monopoly?

In monopolistic competition, there are a relatively large number of firms, not the thousands of firms as in pure competition. The monopolistically competitive firms produce differentiated products, not the standardized products of pure competition. Product differentiation means that monopolistic competitors engage in some price competition because they have some limited “price making” ability based on the less elastic demand for their particular product. This demand, however, is more elastic than the demand for monopolists’ products. Monopolistic competitors, unlike most monopolists and all purely competitive firms, will engage in nonprice competition that gets reflected in product quality, services, location, advertising, and packaging. Compared with monopoly, the barriers to entry for monopolistically competitive firms are minor. The firms typically are small in size, operate independently, and do not practice collusion. [text: E pp. 486-488; MI pp. 228-230]

2. “Pure competition or pure monopoly industries will tend to be one-price industries. Monopolistic competition, however, is a multiprice industry.” Explain.

Monopolistic competition has the fundamental feature of product differentiation. This gives each firm a slight degree of monopolistic control over price. Consumers have preferences for the products or services of specific sellers and within limits will pay a higher price to satisfy those preferences.

In pure competition the demand curve facing each individual seller is perfectly elastic because all products are standardized. The seller and buyer must accept the market price in buying and selling. At the opposite extreme, a pure monopoly is the only seller and so is able to set the price. [text: E pp. 486-488; MI pp. 228-230]

3. How does economic rivalry take place in monopolistic competition? Describe the different aspects of product differentiation and price competition.

Nonprice competition is the typical type of economic rivalry that occurs in monopolistic competition. There are several forms of nonprice competition. First, firms may compete by offering consumers different product features or by providing products of varying quality. Second, firms differ in the amount of service or support they provide the consumer. Third, in some monopolistic industries such as restaurants or banking,

444


location becomes a critical factor on which firms compete. Fourth, advertising and packaging build loyalty to a particular brand or make one product more appealing to the consumer. Although monopolistic competitors have some degree of control over price, the nonprice competition can be of even greater importance in influencing or meeting consumer tastes and preferences. [text: E pp. 487-488; MI pp. 229-230]

4. What are types of firms that exemplify monopolistic competition?

Most types of retailing in metropolitan areas are handled by monopolistically competitive firms. The retail stores would include gasoline stations, restaurants, clothing stores, shoe stores, and so forth. On the manufacturing side, there would be companies that publish books, make plastic pipes, make cardboard boxes, produce leather goods, or construct wood furniture or cabinets. [text: E p. 488; MI p. 230]

9. A monopolistically competitive firm is producing 50 units of output in the short run where marginal cost is $3.00, average total costs are $5.00, price is $4.50, average variable cost is $4.00, and marginal revenue is $3.00. How much profit is the firm making? What output recommendation would you make for the firm?

The firm should not change the level of output because it is maximizing profits at the output level of 50 where the marginal cost of $3.00 is equal to the marginal revenue of $3.00. At that output, however, the firm is incurring $0.50 economic losses per unit ($4.50 price minus $5.00 average total cost) for a total economic loss of $25 ($0.50 times 50 units). The firm cannot operate under these conditions in the long run and will go bankrupt. [text: E pp. 488-490; MI pp. 230-232]

11. If monopolistically competitive firms have some control over their prices, why don’t they set price above average total cost so they will realize an economic profit in the long run?

Entry is relatively easy in monopolistic competition. If a representative firm is earning economic profits in the short run, this condition will not persist as new firms enter the industry with the expectation of earning economic profits. As new firms enter, the demand curve faced by the typical firm will fall and become more elastic which tends to cause the disappearance of economic profits.

Economic profits might persist in a few cases where product differentiation is very strong, or because some firm has some sort of permanent advantage such as location or especially effective advertising. [text: E pp. 488-490; MI pp. 230-232]

12. What are two real-world complications with the long-run conclusion about the representative firm in the model of monopolistic competition?

In the long run, the representative firm in monopolistic competition should break even and earn only a normal profit. This conclusion, however, may not be true for all firms in the real world. First, economic profit may accrue in the long run because there may be some degree of monopoly power that is long term. Some firms may earn some economic profits even in the long run if the firm has a product or service that is not easy to duplicate or it has an extremely good location. Second, product differentiation creates a financial barrier to entry that may not be easy to overcome. [text: E pp. 490-491; MI pp. 232-233]

15. Why do monopolistically competitive firms spend funds for product differentiation and advertising when this practice only adds to the firm’s costs?

445


The long-run equilibrium condition for the representative firm in monopolistic competition indicates that the firm will only break even or earn normal profits. The firm, however, may try to improve on this long-run condition by spending funds on new product differentiation or advertising. These expenditures may be justified and delay the long-run equilibrium if demand increases by an amount sufficient to cover these costs. The firm is unlikely to improve its economic profits through price cutting, so some form of nonprice competition is needed. Spending funds for product differentiation, product development, or advertising makes sense if demand increases and the new revenues cover these costs. [text: E p.492; MI p. 234]

16. Explain how monopolistically competitive producers try to improve on the condition of just breaking even in the long run. Is this improvement a benefit for consumers?

Firms use product differentiation and product improvement as a long-run strategy to make their products significantly different from those produced by their rivals. The use of these tactics can make a product unique and tend to make the demand for the product more inelastic. They can also increase the demand for the product, which would increase the firm’s profits when costs remain constant or increase at a slower rate than revenues.

Product differentiation is achieved through differences in product quality and the introduction of new brands, types, styles, and other forms of nonprice competition. Product improvement encourages technological innovation and change that makes a product better over time.

Whether product differentiation and product improvement contribute substantially to more consumer welfare is a debatable question, and there are trade-offs. Consumers will enjoy more choice and variety in the selection of products under monopolistic competition, but it also creates more excess capacity and economic inefficiency. [text: E p. 492; MI p. 234]

17. Explain why the economic analysis of monopolistic competition is so complex.

The model of the monopolistically competitive firm as presented in this chapter is a simplification of a great deal of complexity that is found in this market structure. The monopolistically competitive firm has some control over the three factors (price, product, and promotion) but there are many combinations of these factors for a particular firm. The model of the representative firm in monopolistic competition does not take into account all the combinations or all the degrees to which these factors can be changed. In addition, the basic model also does not take into account how rivals will react to changes in any one of the factors. [text: E pp. 492-493; MI pp. 234-235]

18. What are the basic characteristics of oligopoly? How does oligopoly compare with the other market structures?

Oligopoly exists when just a few large firms dominate a market in contrast to a pure monopoly where one firm dominates the market. The few firms often have some control over price, but that control is more limited than in pure monopoly because of the interdependence and some degree of competition in the industry. Each firm must consider the reactions of rivals when considering changes in output and price.

The barriers to entry that explain why monopoly exists also explain why oligopolies exist. These entry barriers are the result of economies of scale in an industry where economic efficiency is increased when a few firms supply output for a market. They can also arise from ownership of patents, exclusive licenses, substantial control over essential resources, and merger.

446


As with monopolistic competitors, oligopolies can compete on the basis of price or use nonprice competition. The role of nonprice competition is most important for differentiated oligopolies that are found in consumer goods industries producing such products as breakfast cereals, automobiles, camera film, and cigarettes. Homogeneous oligopolies that produce standardized products would engage in less nonprice competition although they might compete on the basis of service. Examples of homogeneous oligopolies would be firms that produce metals (steel, aluminum, or copper) or chemicals. Oligopolies are common throughout American industry.The purely competitive firm produces a standardized product at the market price. Unlike oligopoly, the firm is small in size, there are no interdependencies among firms, the firm has no control over price, and uses no advertising or nonprice competition. [text: E pp. 493-494; MI pp. 235-236]

25. Explain in nontechnical terms why oligopolistic prices may tend to be inflexible.

An oligopolist will hesitate to raise its prices in the absence of collusion because if its rivals do not follow with price rises of their own the firm will lose market share to these rivals. The oligopolist will also hesitate to lower its price because it assumes that its few rivals will immediately feel the impact in terms of lost market share, and they will also have to lower their prices to maintain their market position. Since each oligopolist will be reluctant to raise or lower prices in the absence of collusion, this leads to inflexible prices. [text: E pp. 497-500; MI pp. 239-242]

26. Describe the essential features of the kinked-demand model of oligopoly pricing.

In the kinked-demand model, there is no collusion. The demand curve for the oligopolist is “kinked” because when the firm lowers its price, its rivals will lower their prices, and its demand often will be inelastic. When the firm increases its price, its rivals will not follow with price increases and its demand will be elastic. The firm, therefore, hesitates to change its price for fear of decreasing its profits. Two shortcomings of the kinked-demand model are that it does not explain how the going price gets set and prices are not as inflexible as implied by the model. [text: E pp. 497-500; MI pp. 239-242]

29. Explain the collusive pricing model of oligopoly behavior.

The collusive pricing model is similar to the pure monopolist model of pricing. In this case, firms collude and act as one firm to set price and output that maximize joint profits of all firms. The methods of collusion may be overt, as in the OPEC oil cartel, or they may be covert as in “a tacit understanding.” There are also a number of obstacles to collusion that make it difficult to sustain over time: differences in demand and costs for firms; the number of firms in an agreement; incentives to cheat; changing economic conditions; entry by other firms; and legal restrictions and penalties. [text: E pp. 500-502; MI pp. 242-244]

32. What obstacles might a group of oligopolists encounter in forming a cartel? A tacit understanding?

First, within the United States both forms of collusion are violations of existing antitrust laws. A tacit understanding would be more difficult to detect, and may not face as tough a barrier as the cartel.

Where cartels are legal, obstacles still exist. Demand and cost differences may make it difficult for producers to agree on price and market share. The number of producers may make any agreement difficult to enforce, and in any case, there will be an economic

447


incentive to cheat, which is another obstacle to successful collusion. The potential for new entrants into the industry is the last obstacle that tends to inhibit collusion of both kinds. In this latter regard, a cartel would have more ability to prevent potential entrants than a simple tacit understanding and so has more chance for success in overcoming this obstacle. [text: E p. 502; MI p. 244]

33. What is the price leadership model of oligopoly pricing and what are its tactics?

Price leadership is a covert and generally legal form of collusion in which one firm traditionally initiates price changes and the other firms in the industry follow the lead. Three price leadership tactics have been observed. First, price adjustments tend to be made infrequently and only as cost and demand conditions change to a significant degree. Second, the price leader will announce price changes through speeches, announcements, or other such activities to solicit a consensus. Third, the going price may not maximize profit in the short run for the firms in the industry, especially if the firms want to prevent entry by other firms. [text: E pp. 502-503; MI pp. 244-245]

34. Why is there emphasis on nonprice competition in oligopoly?

The reasons stem from two basic facts. First, nonprice competition is less likely to get out of hand than is price competition. Price competition among oligopolists can lead to costly price wars because any price change can be easily matched by a rival firm. Nonprice competition is less easy to duplicate and may give an oligopolist a temporary or permanent advantage over a rival. The areas for nonprice competition might entail product changes, improved production or services, or advertising campaigns. Second, oligopolies have greater financial resources to invest in nonprice competition in such areas as product development or advertising. Oligopolists have more resources than monopolistic competitors to engage in this type of competition for long periods of time. [text: E pp. 503-504; MI pp. 245-246]

35. Describe the positive and negative views of the economics of advertising.

The arguments over advertising focus on three major questions: (a) Is advertising persuasion or information? (b) Does advertising promote monopoly power or competition? (c) Does advertising contribute to economic waste or economic efficiency?

In the positive view, advertising gives consumers information about product characteristics and prices that help them make more rational purchases, and promotes consumer welfare by reducing “search” costs. Advertising also gives firms the ability to compete with other firms for market share, thereby promoting rather than restricting competition. This increased competition increases awareness of substitute products, reduces each firm’s product demand, and makes the demand curve more elastic. Overall, advertising contributes to economic efficiency by reducing consumer search costs and creating awareness of other products, by promoting more competition among firms, and by permitting the introduction of new technology. More competition contributes to the realization of allocative and productive efficiency.

In the negative view, advertising manipulates consumer demand through persuasion. It also creates “brand loyalty” that makes the demand curve more inelastic, and fosters monopoly power among the successful firms in an industry. Advertising is also criticized for being wasteful, and for preventing the realization of both allocative and productive efficiency. Advertising can also be self-canceling or offsetting, and thus a waste of resources. [text: E pp. 504-505; MI pp. 246-247]

448


New 39. (Last Word) Describe the major demand and supply factors that have turned the beer industry into an oligopoly over the years.

In 1947 there were 400 independent brewers in the U.S., but today the two major brewers account for almost 70 percent of the market. One reason for this change is that demand changed. Preferences shifted from stronger-flavored beers to lighter, dryer products. Consumption also shifted from taverns to homes, which resulted in a different kind of packaging. On the supply-side, technology changed and produced significant economies of scale that now constitute a barrier to entry. Although mergers have occurred, they are not the fundamental cause of increased concentration. Advertising and product differentiation have been important in the growth of some firms and as a way to create market dominance. [text: E p. 506; MI p. 506]

B. Answers to Short-Answer, Essays, and Problems – Chapter 13

2. Explain and give examples of invention. What does government do to protect it?

Invention is the most basic part of technological advance and involves the discovery of a product or process. It involves the use of imagination, problem solving, and experimentation, and provides the first proof that the new product will work. Examples of different inventions include the first prototype of the light bulb, telephone, radio, television, or personal computer. Governments encourage invention by providing the inventor with a patent, which is an exclusive right to sell a product for a period of time (now 20 years from the time of application). [text: E p. 511; MI p. 253]

3. How does innovation differ from invention and diffusion? How does innovation affect competition among firms?

Innovation is the first successful commercial use of a new product or method, or the creation of a new form of business. There are two major types: product innovation, which involves new and improved products or services; and process innovation, which involves new and improved production or distribution methods. Diffusion is the spread of an innovation through imitation or copying. New and existing firms copy or imitate successful innovations of other firms to profit from new opportunities or protect their profits. Innovation is an important factor in competition because it can enable a firm to “leapfrog” competitors by making their products or methods obsolete. [text: E p. 511; MI p. 253]

4. Describe R&D expenditures in the United States. What percentage of spending goes for invention, innovation, and diffusion?

In 2000, total research and development spending by government and business was 2.64 percent of GDP. This spending is highest compared to other major industrial nations. In business, research and development (R&D) includes work and expenditures directed toward invention, innovation, and diffusion. U.S. business firms spend about 72 percent of their R&D expenditures on activities related to innovation and diffusion. Another 22 percent of expenditures goes for invention. The remaining 6 percent is spent on basic research. Government also supports R&D through defense expenditures and the funding of other activities. [text: E pp. 511-512; MI pp. 253-254]

5. Compare and contrast the modern view of technological advance with the traditional view.

The traditional view of technological advance was that it was external to the economy. It was a random force to which the economy adjusted and was dependent on the advance of science. Technological advance led to the creation of new products that enhanced or

449


maintained profits for firms. After developing the new products, firms returned to their long-run equilibrium positions.

The modern view is that technological advance is internal to capitalism. Intense rivalry among individuals and firms motivates them to seek and exploit new or expand existing opportunities for profit. Many advances in science are also motivated by the potential for commercial use or profit. Entrepreneurs and other innovators are the drivers of technological advance in a capitalistic system. [text: E pp. 512-513; MI pp. 254-255]

6. In what ways do entrepreneurs differ from other innovators? In what types of businesses do entrepreneurs and innovators tend to work? How do past successes affect these types of individuals?

The entrepreneur is an initiator, innovator, and risk bearer. Other innovators are key people involved in the pursuit of innovation, but who do not bear personal financial risk. Entrepreneurs often form small new companies called startups, which are firms that create and introduce a new product or production technique. Other innovators are found within existing corporations. R&D work in major corporations has resulted in technological improvements, often by splitting off units to form innovative firms. [text: E p. 513; MI p. 255]

9. Why do entrepreneurs and other innovators actively study the scientific output of universities and government laboratories?

New scientific knowledge is important to technological advance. The scientific results from university and government laboratories are studied by entrepreneurs to find those with commercial applicability. Government and university laboratories have developed many new products and processes that have found commercial use and made profits for firms and entrepreneurs. [text: E p. 5145; MI p. 256]

10. What are the many different sources of funding to finance firms’ R&D expenditures? If an entrepreneur uses personal funds is there a cost for financing?

Several sources are available for financing firms’ R&D activities. The firm can borrow money from a bank. More established firms may be able to issue bonds to raise money for the venture. Profitable firms can also retain their earnings and use them to finance R&D expenditures. Smaller start-up firms may be able to obtain venture capital for a research project. Individual entrepreneurs may also use personal savings to finance the R&D for a new company. In this last case, the marginal cost of the financing using personal funds is the foregone interest rate. [text: E pp. 514-515; MI pp. 256-257]

11. Explain how the firm decides on the optimal amount of research and development.

The optimal amount of research and development for the firm depends on the marginal benefit and marginal cost of R&D activity. To earn the greatest profit, the firm will expand an activity until its marginal benefit equals its marginal cost.

A firm’s marginal cost of these funds is an interest rate i. A firm’s marginal benefit of R&D is its expected profit (or return) from the last dollar spent on R&D. The optimal amount of R&D in marginal cost and marginal benefit analysis is the point where the interest-rate cost-of-funds (marginal cost) curve and the expected-rate-of-return (marginal benefit) curve intersect. [text: E pp. 515-517; MI pp. 257-259]

12. Why might many R&D expenditures be affordable, but not worthwhile? Are outcomes from R&D guaranteed?

450


R&D expenditures can be justified only if the expected return equals or exceeds the cost of financing them. If the marginal benefit of an R&D expenditure is less than the marginal cost, then the expenditure may be affordable but it is not worthwhile. The firm expects positive outcomes from R&D, but the results are not guaranteed. Obviously, an R&D expenditure has an element of risk that it will not prove to be profitable no matter how much planning was done or prior information was obtained before making the investment decision. It is the potential for success, not the guarantee of it, that is the driving force behind the final decision. [text: E pp. 516-517; MI pp. 258-259]

New 13. A firm decides to make a $10 million expenditure on research and development that will create a new product. This product is expected to increase the firm’s revenues by a total of $12 million in the next year. The firm also estimates that the production cost of the new product will be $11 million. (a) What is the expected rate of return on this research and development expenditure? (b) If the firm has to take out a loan to finance the project, what is the highest interest rate they will pay and still do the project? Explain.

(a) 10 percent (b) The expected rate of return is 10 percent. The firm will take out a loan for any interest rate up to 10 percent because they expect to still make money on the investment. [text: E pp. 515-517; MI pp. 257-259]

16. Describe how a firm’s revenues and profits are increased through product innovation. What three other points should be noted about these results?

Technological change can increase a firm’s profit by increasing revenues through product innovation. From a utility perspective, consumers will purchase a new product only if it increases total utility from their limited income. The purchases of the product increase the firm’s revenues.

Three other points are noteworthy about these results. First, consumer acceptance of a new product depends on both its marginal utility and its price. To be successful, a new product must not only deliver utility to the consumer but do so at an acceptable price. Second, many new products are not successful, so the firm may fail to realize the expected return. Third, most product innovations are small or incremental improvements to existing products and not major changes. [text: E pp. 517-518; MI pp. 25-260]

17. A consumer makes purchases of an existing product A such that the marginal utility is 40 and the price is $20. The consumer also tries a new product B and at the current level of consumption it has a marginal utility of 72 and a price of $24. What does the utility-maximizing rule suggest that this consumer should do?

Increase consumption of product B and decrease consumption of product A because the marginal utility per dollar spent on A is 2 (40/$20) while the marginal utility per dollar spent on B is 3 (72/$24). More utility per dollar spent is obtained from consuming B, so more should be consumed until the marginal utility per dollar spent on both products is equal. [text: E pp. 517-518; MI pp. 259-260]

19. Explain how process innovation reduces cost and increases profits. How does this innovation affect the firm’s total product curve and average cost curve?

Process innovation, the introduction of better ways to make products, is another means of increasing profit and obtaining a positive return on R&D expenditures. For example, a firm may develop a better way of making a product that requires fewer steps or makes better use of labor resources. This innovation results in a shift upward in the firm’s total

451


product curve and a shift downward in the firm’s average total cost curve that increases the firm’s profit. [text: E pp. 519-520; MI pp. 261-262]

24. Describe the legal protections and potential advantages of taking the lead in innovation.

Taking the lead in innovation has several protections and potential advantages for the firm. (1) Patents limit imitation and protect profits over time. (2) Copyrights and trademarks reduce direct copying and increase the incentive for product innovation. (3) Brand names may provide a major marketing asset. (4) Trade secrets and learning-by-doing give firms an advantage. (5) The time lags between innovation and diffusion give innovators time to make substantial economic profits. (6) There is the potential purchase of the innovating firm by a larger firm at a high price. [text: E pp. 520-521; MI pp. 262-263]

B. Answers to Short-Answer, Essays, and Problems – Chapter 14

3. Why aren’t the tools of product market analysis directly applicable to the resource market?

The demand for resources is a derived demand, that is, it is derived from the demand for the products that these resources produce. The demand side of the resource market must be analyzed from that indirect perspective.

Another distinction between the product and resource markets is on the supply side. Some resources, especially land, are essentially fixed in quantity. Other resources, particularly labor, are not always mobile and again the quantity cannot always be varied. In addition to these complexities, resource markets tend to be more subject to institutional forces including the policies and practices of governments, labor unions, and business organizations. [text: E pp. 533-534; MI pp. 275-276]

4. Why is the demand for resources called a “derived” demand? On what two factors does the strength of the demand for resources depend? How are these two factors related?

The demand for a resource is “derived” from or depends on the demand for the goods and services that the resource can produce. For example, the demand for workers in the computer industry depends on the demand for computers.

Underlying the demand for resources are two other critical factors. First, the demand for resources depends on the marginal productivity of the resource. Second, the demand for a resource depends on the price of the product that the resource produces. The two factors are related through the concept of marginal revenue product, which is the basis for the resource demand curve. In pure competition, marginal revenue product for an additional unit of a resource is simply the marginal productivity of the resource multiplied by product price. [text: E pp. 533-534; MI pp. 275-276]

5. Why is the marginal revenue product schedule a demand schedule for the individual firm in a purely competitive resource market and selling output in a purely competitive product market?

Underlying the demand for a resource is the marginal productivity of the resource and the price of the product the resource produces. The marginal product of an additional unit of a resource will decrease because of the law of diminishing returns. In competitive resource markets, the price of the product for the firm will remain constant. Thus, the marginal revenue product (MRP) will fall as more units of resource are hired because of diminishing marginal productivity, giving a demand schedule that shows the

452


inverse relationship between the price of the resource and the quantity of the resource employed.

The number of resources hired depends on where the marginal resource cost (MRC) equals the marginal revenue product (MRP) along the downsloping MRP curve. As MRC falls, the firm can afford to hire more workers, so long as MRP equals MRC. The MRP schedule is the firm’s demand curve for labor because, by applying the MRP = MRC rule, it shows the amount of resources that the firm will hire at each specified resource price. [text: E pp. 533-534; MI pp. 275-276]

7. What is the difference between the demand curve for a resource under pure competition and under imperfect competition?

The demand for a resource depends on the marginal productivity of the resource and the price of the product the resource produces. In purely competitive markets, the price of the product remains constant and only the marginal product of an additional unit of a resource changes. The MRP curve or the firm’s resource demand curve declines solely because of diminishing marginal productivity. In imperfect competition, the price of the product will decline as more output is produced and marginal productivity will also decline. Thus the two factors on which resource demand depends will decline. The result is that the resource demand, or MRP curve, will tend to fall faster and be less elastic (resource employment will be less responsive) to a change in resource price for the imperfectly competitive firm compared with the purely competitive producer. [text: E pp. 535-536; MI pp. 277-278]

8. Contrast the factors that underlie the downsloping resource demand curve with those which underlie the downsloping product demand curve.

The downsloping resource demand curve is related to the resource’s MRP schedule. A firm will hire additional units of a resource as long as each successive unit adds more to the firm’s revenue than it does to its costs. The factors behind the MRP curve’s downward slope include diminishing returns to a factor of production as successive amounts are added in the short run, and the fact that the demand for the product produced is downward sloping also causing marginal revenue to decline as successive product units are produced. The downsloping product demand curve is thus one factor in the downsloping resource demand curve and the factors which cause the product demand curve to slope downward are the income and substitution effects. Since resource demand is a derived demand, these factors indirectly affect the shape of the resource demand curve. [text: E pp. 535-537; MI pp. 277-279]

New 14. What is the difference between a change in resource demand and a change in the quantity of a resource demanded? What factors contribute to a change in resource demand or a change in the quantity of a resource demanded?

A change in resource demand is a shift of the entire demand curve or schedule of the resource to the right or left. A change in the quantity of a resource demanded is a movement along a given resource demand schedule or curve. A change in resource demand is caused by: (a) a change in the demand for the product for which the resource is an input; (b) a change in the productivity of the resource; and (c) a change in the prices of other resources that are substitutes or complements of the resource. The sole cause of a movement along an existing resource demand curve is a change in the price of the resource [text: E pp. 535, 537-539; MI pp. 277, 279-281]

15. How will a change in productivity change the demand for a resource? What three factors will affect productivity?

453


Other things equal, an increase in the productivity of a resource will increase the demand for the resource. Also, a decrease in the productivity of a resource will decrease the demand for the resource. Thus, changes in productivity change resource demand in the same direction.

Three factors can affect the productivity of a resource. First, the quantities of other resources will affect productivity. The greater the amount of other resources such as capital or land, the greater will be the productivity of labor. Second, technological progress will improve the quality of resources and this change will increase productivity. If there is a technological improvement in capital goods, it can increase output. Third, improvements in the quality of the resource, such as labor, can increase productivity. Education and training, for example, may increase worker quality and thus enable these workers to be more productive. [text: E pp. 537-538; MI pp. 279-280]

18. Does it matter whether capital and labor are substitutes or complements when figuring out what will happen to the demand for labor if the price of capital increases? Explain.

Answer: Yes, it does. If labor and capital are substitutes in production, the demand for labor can either increase or decrease depending on the magnitudes of the substitution and output effects. With the substitution effect, an increase in the price of capital will cause more labor to be used in place of capital. With the output effect, an increase in the price of capital will cause production cost to increase, output to decrease, and for less labor and capital to be used. If the substitution effect is greater than the output effect, the demand for labor will increase. If the substitution effect is less than the output effect, the demand for labor will decrease.

If labor and capital are complements in production, there will be no substitution of labor for capital. The output effect, however, will be negative because production costs increase with the increase in the price of capital. This result leads to less use of both labor and capital. The combined effect is that the demand for labor decreases. [text: E pp. 538-539; MI pp. 280-281]

19. Compare and explain the significance of the substitution and output effects as they apply to resource pricing. What relationship, if any, do they bear to the income and substitution effects discussed in connection with product demand?

In both cases the effects apply to the relationship of the product or resource to its substitutes. In the case of resource pricing, if the price of a substitute resource declines, this will cause a decrease in the demand for the original resource as producers hire more of the substitute. However, there may be an offsetting output effect, as lower costs mean that the producer will find it profitable to produce and sell a larger output that may require more employment of all resources including the one that was originally displaced.In the case of the income and substitution effects discussed with regard to product demand, they tend to reinforce one another in the case of a normal good. If the price of a substitute product declines, it will cause a decrease in the demand for the original product because buyers will buy more of the now lower-priced substitute in place of the original product. However, buyers will also find that they have more income left to spend since their costs have declined and this may cause them to buy more of everything. [text: E pp. 538-539; MI pp. 280-281]

20. Indicate how the following events will shift the firm’s demand curve for labor: increase it (I); decrease it (D); keep it the same (S).

___ Technological advances increase labor’s productivity.___ The wage rate increases.

454


___ The demand for the product that labor produces decreases.___ The wage rate decreases.___ Absenteeism reduces labor’s productivity.

I Technological advances increase labor’s productivity. S The wage rate increases. D The demand for the product that labor produces decreases. S The wage rate decreases. D Absenteeism reduces labor’s productivity.

[text: E pp. 537-539; MI pp. 279-281]

24. What effect, if any, will each of the following have upon the elasticity or the location of the demand curve for resource J that is being used in the production of commodity X? If there is uncertainty as to the precise effect, explain the sources of that uncertainty.(a) A decline in the demand for product X.(b) An increase in the price of Y, a substitute product for X.(c) A decline in the price of substitute resource K.(d) A decline in the number of available resources that are substitutable for J in the production of X.(e) An increase in the price of complementary resource L.(f) An increase in the elasticity of demand for product X due to an increase in the number of sellers in the market.

(a) The demand curve for J would shift leftward, as less X is sold at existing prices.(b) The demand curve for J would shift rightward, as more X is sold at existing prices due to a rise in the relative price of substitute product Y.(c) The demand curve for J would shift leftward as producers substitute resource K, which is relatively less expensive now.(d) The demand curve for J would become less elastic (more inelastic) as the number of available substitutes declines.(e) The demand curve for J would shift leftward because J and L are used in a complementary manner and the combination is now more expensive. This causes the demand for J to be less.(f) If the elasticity of demand for X increases, the elasticity of demand for J should also increase unless the other sellers also use resource J. In that case, the answer is indeterminate. [text: E pp. 541-542; MI pp. 283-284]

26. Explain briefly and concisely the meaning and significance of the following equation:

This equation shows the profit-maximizing combination of resources, labor and capital in this case, that a firm should employ. It states that the firm should employ both labor and capital up to the point that their marginal revenue products are just equal to their prices, that is, their ratio is equal to 1. If these fractions were greater than one, it would mean that the firm could profitably employ more units of the resources because it would add more to its revenue than to its cost. If these fractions were less than one, it would mean the firm should employ less of the resources because their marginal revenue products are below their marginal cost. [text: E pp. 543-544; MI pp. 285-286]

B. Answers to Short-Answer, Essays, and Problems, Chapter 15

New 2. What is the difference between nominal and real wages?

455


Nominal wages are the amount of money received per hour, per day, per week, or whatever the pay period is. Real wages are the purchasing power of the wages, or the amount of goods and services that can be obtained with the wages. Real wages depend not only on nominal wages, but also on the price level of the goods and services that will be purchased. For example, if nominal wages rose by 6 percent and there is a 3 percent rate of inflation, then the “real” wage increased by 2 percent. [text: E pp. 555-556; MI pp. 297-298]

4. “The higher real wages earned by American workers primarily reflect the fact that Americans have a greater inherent ability to produce goods and services than do foreign workers.” Evaluate.

There is no evidence to suggest that there is an inherent superiority among American workers. However, they have large amounts of capital per worker with which to improve their productivity over many of their less fortunate foreign counterparts. The high productivity in the United States is also related to the abundance of natural resources, high level of technology, and quality of labor in terms of health, education and training, and work attitudes, as well as a relatively stable business environment. It is this high level of productivity resulting from the various factors named which enables American workers to earn high real wages. [text: E pp. 551-552; MI pp. 293-294]

7. A firm’s labor input, total output of labor, and product price schedules are given below. If labor is the only variable input, how much labor should the firm employ if the wage rate is $8 per day?

Units Total output Priceof labor per day of good

2 10 $103 14 94 19 85 23 76 27 67 31 5

The firm should hire 5 workers. The MRP of the fifth worker is $11 and the MRC is $8. [text: E pp. 553-555; MI pp. 295-297]

17. What factors might increase the demand for carpenters in a medium-sized town? Be specific.

One factor would be an increase in the population, which would increase the demand for carpenters’ services, assuming the new residents also required the use of carpenters from time to time. A second factor could be an increase in the demand for the products that require carpenters’ skills, e.g., an increase in new home construction or remodeling of existing homes. A possible third factor might be an increase in productivity on the part of carpenters in general, so that consumers decided to purchase more custom-made furniture, etc., in place of prefabricated goods. A fourth possible factor could be an increase in the price of substitute prefabricated goods, so that the demand for carpenters’ repair and construction work increased. Finally, a possible cause could be an increase in advertising or marketing of carpenters’ services either by individual carpenters or by a carpenters’ union. [text: E pp. 557-558; MI pp. 299-300]

18. What are the economic effects of imposition of a new occupational license or examination on a labor market?

456


The primary effect of occupational licensing or testing is to restrict entry into a profession. The imposition of a new licensing requirement has the effect of reducing the supply of workers who are “qualified” for the job. Given a stable demand for an occupation, the reduction in supply will tend to increase the equilibrium wage in the labor market.

The typical reason that is given for licensing requirements is to make certain that people are qualified for an occupation. However, unnecessarily stringent requirements or difficult tests can serve to restrict entry without significantly increasing worker quality. In these instances, the economic effect of the new rule or regulation serves to increase wages of workers above the competitive wage in that industry. [text: E p. 559; MI p. 301]

New 19. What is the difference between an exclusive union and an inclusive union? What are the economic effects of each type?

A craft union would be an example of an exclusive union. It uses licensing and other means to restrict entry into the union. By controlling the supply of members, who are typically skilled workers, the union can raise the wages of its members. The decrease in the supply of workers, however, also results in the loss of employment for workers who are not licensed or members of the union. An inclusive union would be an industrial union that includes workers who are both skilled and unskilled who work in an industry. The inclusive union tries to raise wages not by reducing the supply of workers, but by bargaining for a higher wage rate for all workers in the industry. The higher wage rate, however, will reduce the total number of workers who are hired in the industry. [text: E pp. 559-560; MI pp. 301-302]

24. What is the case against and the case for the minimum wage? What does the evidence indicate?

The primary argument against the minimum wage is that it will reduce employment of minimum-wage workers. When the minimum wage is imposed above the equilibrium wage in a market, then employers will reduce employment because the marginal revenue product from some minimum-wage workers will be less than the higher marginal resource cost of those workers because of the minimum wage. Although the minimum wage is often proposed as a “living wage” that is designed to get low-wage workers out of poverty, it does not work as a poverty program because it reduces the employment opportunities for low-skill workers.

The case for the minimum wage is based on productivity considerations. If the minimum wage is raised, then there may be a shock effect that encourages businesses to make more productive use of minimum-wage workers that increases their marginal revenue product. Workers who keep their jobs after the minimum-wage hike will also earn more income, which should increase their standard of living and possibly increase the health and motivation of workers. Furthermore, in a monopsonistic labor market, a minimum wage may raise wage rates without increasing unemployment.

The 1980s evidence indicated that a minimum-wage hike reduced employment somewhat especially among teenagers and young adults, with a 10% increase in the wage resulting in a drop in employment of about 1 to 3% depending on the group. More recent research suggests that the employment effect may be small, or close to zero. The unemployment effects, if there are any, fall disproportionately on workers in lower-wage occupations affected by the minimum-wage hike. Those low-skilled workers who remain employed, however, benefit from the increased income. [text: E pp. 562-563; MI pp. 304-305]

457


25. Use the graph below to illustrate and explain what would happen in the labor market if a minimum wage was established at a level above the equilibrium wage.

The labor supply curve would go from Wm rightward to the old supply curve. The level of employment would be determined at the intersection of the demand curve and the new labor supply curve. Before B workers were employed. With the minimum wage A workers will be employed, thus C–A workers will lose their jobs. The A workers who keep their jobs will earn the higher wage, Wm rather than the previous equilibrium wage. [text: E pp. 560, 562; MI pp. 302, 304]

27. Why is there a significant difference in the pay of physicians and construction workers?

The difference can be explained largely in terms of noncompeting groups. The market for physicians is different than the market for construction workers. In the case of physicians, entry into the profession is severely restricted which makes the supply small relative to the demand. The job requires high mental ability and extensive education and training. The education and training is expensive both in monetary terms and in terms of the number of years that a person must devote to it (forgone earnings). Licensing requirements and the limited number of students admitted to medical school also keep the pool of potential physicians small. The demand for physician services, however, is great and expanding. Thus, the equilibrium wage for physicians will be high.

For construction workers, entry into this profession is somewhat restricted by unions, but the barriers are not nearly as high as for physicians in terms of mental ability, financial capability, or time required for education. The supply of construction workers, therefore, will be greater relative to the supply of physicians. The demand for construction workers may be great, but it can also be weak at different times of the year. Thus, with greater supply and weaker demand, the equilibrium wages of the construction workers will be lower than physician wages. Restrictive unions cause the gap to be less than it would be otherwise. [text: E pp. 564-566; MI pp. 306-308]


1. What determines the economic rent for land? Explain from a supply and demand perspective.

Economic rent is the price paid for the use of land (or natural resources) whose supply is basically fixed. The first characteristic, therefore, is that the supply curve for land or natural resources is perfectly inelastic or fixed. Land and natural resources also have no production costs and are a “free” gift of nature, so an increase in economic rents provides no incentive function to bring forth more land. The second characteristic is that demand is the only active determinant of economic rent. As demand rises and falls, then economic rents will rise and fall. [text: E pp. 572-573; MI pp. 314-315]

458


4. Assume that the quantity of a certain type of farmland is 400,000 acres and the demand for this land is that given in the table below.

Pure land rent, Land demanded, per acre acres

$500 100,000400 200,000300 300,000200 400,000100 500,00050 600,000

(a) What will be the economic rent and how much land will be rented?(b) If the productivity of the land increases such that 200,000 more acres are demanded at each price, what will the economic rent be and how much land will be supplied?(c) Given the new demand schedule in (b), if landowners were taxed at a rate of $200 per acre for their land, what would be the economic rent on this land after taxes and how many acres would be rented?(a) The rent will be $200 an acre and 400,000 acres of land will be rented.(b) The new economic rent will be $400 and only 400,000 will still be supplied.(c) The before-tax rent is $400 so the after-tax rent is $200. Still, 400,000 acres would be rented. [text: E pp. 572-574; MI pp. 314-316]

New 12. Why is money not an economic resource? If it is not productive, then why do businesses want to obtain or “buy” it?

The four basic economic resources are land (or natural resources), labor, capital, and entrepreneurial ability. The key characteristic of these resources is that they are productive because they can be used to produce goods and services. Money cannot be used to produce goods and services. Money is simply a paper or token asset in the form of currency, coins, or checkable deposits. Businesses, however, obtain or “buy” money as a way to acquire real capital goods such as plants, equipment, or machinery. Thus, indirectly money gives access to real capital goods. [text: E pp. 555-556; MI pp. 297-298]

13. Briefly explain the loanable funds theory of interest rate determination.

The demand for loanable funds shows the inverse relationship between the interest rate and the quantity of loanable funds demanded. At lower interest rates, more loanable funds will be demanded than at higher interest rates. The demand for loanable funds is a function of the demand for loans expressed by different groups in the economy—consumers, businesses, and governmental institutions. These groups borrow more when the interest rate is low because it is less expensive to borrow money. The supply of loanable funds shows a positive relationship between the interest rate and the quantity of loanable funds supplied. The higher the interest rate, the more incentive households will have to supply loanable funds to financial institutions. Consumers are more willing to forego consumption. When graphed, the demand for loanable funds is a downsloping curve, and the supply of loanable funds is an upsloping curve. The intersection of the supply curve and the demand curve for loanable funds determines the rate of interest. [text: E pp. 576-577; MI pp. 318-319]

15. What factors might cause the interest rates to differ? Explain.

There are about five factors that cause interest rates to differ: (a) Interest rates vary depending on the degree of risk involved in the loan. Loans with higher risk will

459


command higher interest rates. (b) The maturity of the loan can affect the interest rate, with longer terms usually paying higher rates. (c) Loan size can be a factor; smaller loans tend to have higher interest rates than larger loans reflecting administrative costs. (d) Taxation can play a role in affecting loan interest rates. Taxable loans will command a higher rate than nontaxable loans. (e) Market imperfections can give a degree of monopoly power to some lenders causing somewhat higher loan rates. [text: E p. 578; MI p. 320]

16. Economists often speak as if there is a single interest rate when in fact there are many interest rates. What factors explain the differences in these interest rates?

Economists speak as if there is one interest rate for the sake of convenience. Explanations can be confusing if all interest rates are considered. There are, however, many different interest rates. They differ because of five factors: risk; maturity; loan size; taxability; and market imperfections. In general, interest rates will be higher the riskier the loan, the longer the maturity of the loan, the smaller the size of the loan, the greater the taxability of the loan, and the more monopolistic the lend of the loan. [text: E p. 578; MI p. 320]

17. What is the pure rate of interest?

When economists talk about “the interest rate” they are referring to the pure rate of interest that is best measured by the interest paid on long-term and riskless securities, such as thirty-year bonds of the U.S. government. [text: E pp. 578-579; MI pp. 320-321]

18. Distinguish between the nominal and real rates of interest using an example.

The nominal rate of interest is the stated rate of interest, while the real rate of interest is expressed in constant dollars or dollars adjusted for inflation. The real interest rate is the nominal interest rate minus the rate of inflation. In simple terms, if the nominal rate of interest charge on a loan is 7 percent, but the inflation rate is 3 percent, then the real rate of interest received by the institution making the loan is 4 percent. [text: E pp. 579-580; MI pp. 321-322]

19. What are usury laws and what are their economic effects?

Usury laws impose a legal price (or interest rate) ceiling on the rate of interest that can be charged by banks and other financial institutions. If the interest-rate ceiling is below the equilibrium interest rate there are three economic effects. First, there will be a shortage of money available for loans or “lending.” This shortage will require rationing by banks to the most credit-worthy customers. These customers generally have higher income, thus the poor tend to be hurt by the nonmarket rationing schemes of financial institutions that are designed to address the shortage. Second, credit-worthy borrowers will gain because they are borrowing at below competitive market interest rates while lenders (financial institutions and their stockholders) will lose because they are required to lend at below market interest rates. Third, the interest rate is a price that provides information and incentives for allocating scarce resources in the economy. Interest-rate ceilings impair the guiding function of price in a market economy and can lead to inefficient allocation of resources. [text: E pp. 580-581; MI pp. 322-323]

21. Why is the interest rate such an important price in the economy?

The interest rate affects both the level and composition of investment goods production. There is an inverse relationship between the interest rate and investment. Higher interest rates will restrict investment goods production and lower interest rates will

460


encourage investment goods production. Lower interest rates will encourage investment, and therefore enhance the short-term and long-term growth in the economy.

The interest rate also affects the composition of investment goods production by allocating capital to those projects that have the best prospects for profitability. The interest rate rations scarce money capital, and therefore physical capital, to those activities in the economy with the best rate of return or which are the most productive. [text: E p. 579; MI p. 321]

22. What role does the interest rate play in the economy? Is the distinction between real and nominal interest rates an important one in discussing these roles?

The interest rate plays several roles in the economy. First, it affects the total output because of the inverse relationship between the interest rate and investment spending; governments often try to influence the interest rate to achieve policy goals. Second, it rations (or allocates) financial and real capital among competing firms and determines the composition of total output of capital goods. Third, it changes the level and composition of spending on research and development. These effects are based on changes in the real interest rate, which is the rate expressed in inflation-adjusted dollars, and not the nominal interest rate, which is the rate expressed in current dollars. It is the real interest rate, not the nominal interest rate, which affects investment decisions. [text: E pp. 579-580; MI pp. 321-322]


New 1. What are the basic purposes of antitrust policy?

Antitrust policy has three basic objectives. First, it seeks to prevent monopolization of an industry in which one firm or a dominant firm controls an industry. Second, it strives to promote competition in markets so that there is no harmful manipulation of price and output by a firm. Third, it promotes economic efficiency in the economy. [text: E p. 632; MI p. 374]

New 2. Briefly describe the historical background that gave rise to antitrust and regulation in the United States.

The history of antitrust and regulation essentially began in the decades following the Civil War. It was in this period that the modern form of corporate business began to develop and “trusts” or monopolies were formed in industries such as petroleum, meatpacking, railroads, sugar, lead, coal, whiskey, and tobacco. Questionable tactics and business practices were used by some of these trusts to monopolize industries and extract price concessions from resource suppliers. Farmers and small business were vulnerable to the pricing power of the large trusts. The opinions of consumers, labor unions, and economists also turned against the economic power of the trusts and large businesses that dominated an industry. [text: E p. 636; MI p. 378]

5. Explain: “Antitrust is basically pro-business, because it is antimonopoly. To believe that it is antibusiness is to believe that monopoly is pro-business.”

Clearly the response to this quote depends on which side of the fence you are on. Large firms seeking to consolidate more power would not agree that antitrust is pro-business. However, from the standpoint of the consumer and small- to medium-sized businesses, this statement makes sense. Antitrust laws promote competition and protect competition from monopolistic power. [text: E pp. 632-633; MI pp. 374-375]

8. What was the importance of the Federal Trade Commission Act of 1914?

461


The act set up an independent government agency to investigate and to enforce antitrust laws and the provisions of the Clayton Act. The act also broadened the range of illegal business practices that could be regulated. For example, the commission could hold hearings on unfair methods of competition and also issue “cease-and-desist orders” when business practices were deemed unfair for commerce. The Wheeler-Lea Act of 1938 extended FTC power by giving the commission the authority to protect the public against deceptive or misleading advertising. [text: E p. 634; MI p. 376]

10. What historic legal cases support the behavioralist and structuralist views of the antitrust laws? What has been the recent view of antitrust laws?

In the U.S. Steel case of 1920, the courts applied the rule of reason to the issue of monopoly. Monopoly was considered to be illegal only if it behaved in an illegal fashion and sought to dominate a market. The mere fact that U.S. Steel was a large firm possessing monopoly power did not make it illegal.

The contrasting view was offered in the Alcoa case of 1945. The mere fact that Alcoa controlled 90% of the aluminum ingot market was reason for the court to rule that the firm violated antitrust law. In this case, structure mattered more than behavior.

Current decisions have swung back to the rule of reason and away from a strict structuralist view of antitrust. Factors that come into play in this position have to do with interindustry and foreign competition that tend to lessen concentration even in highly concentrated domestic industries. Also, there has been more focus on monitoring the monopoly effects of mergers on a case-by-case basis and on more intensive investigation of price fixing, no matter what size the firm. [text: E pp. 634-635; MI pp. 376-377]

New 14. Describe the three types of mergers and give examples.

There are horizontal, vertical, and conglomerate mergers. (a) Horizontal mergers are between companies selling similar products in the same market. Two examples are the Chase Manhattan bank merger with Chemical Bank, and Boeing’s merger with MacDonald Douglas. (b) Vertical mergers are between firms at different stages of the production process in the same industry. An example would be Pepsico’s merger with three restaurants—Pizza Hut, Taco Bell, and Kentucky Fried Chicken (now Tricon Global Restaurants). (c) Conglomerate mergers are between firms in unrelated industries such as that between Walt Disney Company (movies) and American Broadcasting (radio and television) or between America Online (Internet service) and Time Warner (publishing and broadcasting). [text: E p. 637; MI p. 379]

17. On occasion the government has approved the merging of certain smaller firms in oligopolistic industries (such as steel and automobiles) on the grounds that the net result would strengthen competition. Do you think that this is sound policy? Justify your answer.

The basic point here is that combinations of small firms can provide stronger competition to the industry leaders. Whether or not it is sound policy would depend on the industry circumstances. If there are two or three major firms, then merger of smaller firms to create a fourth or fifth major firm would seem to strengthen competition. On the other hand, if there are only two major firms where one is larger than the other, it does not seem to be good policy to allow the second one to merge and grow to the point where there are only two giant firms. In other words, weakening competition from below does not seem to make sense if the concentration at the top is narrowed as a result.

462


In judging such policies, the threat of interindustry and foreign competition should also be taken into account. [text: E pp. 636-637; MI pp. 378-379]

19. What has been the general approach to the enforcement of antitrust laws based on the type of mergers and price fixing?

Charges of price fixing are vigorously investigated by the government and the practice of price fixing when it is found is punished. Even actions that contribute to price fixing, such as agreements to split up the market, are punished.

The application of antitrust law to mergers varies based on the type of merger. Conglomerate mergers are generally permitted. Vertical mergers are not prohibited because they do not substantially lessen competition. Horizontal mergers are scrutinized, but may be permitted depending on the circumstances. If a firm is going bankrupt it can be permitted to merge with another firm. If an industry is subject to strong foreign competition, domestic firms in the industry may be permitted to merge. The circumstances are examined on a case-by-case basis to determine the degree to which competition might be lessened in an industry when there is a horizontal merger. [text: p. 638; MI p. 380]

New 20. How is price fixing treated under antitrust policy? Give two examples of legal actions against price fixing.

Price fixing is treated strictly. Evidence of price fixing, by large or small firms, will be cause for antitrust violations. Just the attempt to fix prices or to rig market outcomes are considered illegal even if they are not successful in increasing monopoly dominance. Such violations are called per se violations because they are illegal in and of themselves and are not subject to the rule of reason. Several recent examples are: (a) Archer Daniels Midland (ADM) admitting to fixing the price of an additive to livestock feed, a sweetener made from corn, and citrus acid and (b) ConAgra and Hormel paying a $21 million fine to settle their roles in a price fixing case with catfish. [Note: other examples could also be given for a. and b.] [text: E p. 638; MI p. 380]

22. Explain: “An effectively regulated natural monopoly will have trouble attracting capital to sustain and modernize its facilities.”

The answer to this question hinges on what is meant by the wording “effectively regulated.” If this wording means setting price equal to marginal cost, then the statement is indeed true. Marginal costs for a natural monopoly are less than average costs. A price equal to marginal cost therefore will be a price (average revenue) that is below average cost. Suffering losses, the firm will find it difficult to attract capital to sustain and modernize its facilities.

If the wording in the question means setting rates to allow for a fair return, then the statement may or may not be true. “Economic” profits do not occur under this type of “effective regulation.” However, it is the promise of “economic” profits that is most attractive to investors. Therefore, the statement may be true especially during periods of prosperity. On the other hand, despite the fact that a well-regulated monopoly promises only “normal” returns, there is little risk involved in achieving at least that amount of return. This security of investment might offset the lack of incentive that “economic” profits provide. [text: E pp. 639-641; MI pp. 381-383]

New 24. What have been the major outcomes from deregulation of industry? Give three examples of changes in particular industries.

463


The economic effects have generally been positive. Society has benefited from lower prices, lower costs, and increased output. There has also been more technological advance and innovation in deregulated industries. Airline fares, adjusted for inflation, have declined by one-third while airline safety has improved. Rates for trucking and rail transportation have fallen by half. There has been a drop in the cost of telecommunication and brokerage services. Deregulation has sparked technological innovations in telecommunications and related industries. [text: E p. 642; MI p. 384]

25. What are the major differences between “industrial” regulation and “social” regulation? Cite examples of Federal commissions that address the two types of regulation.

The focus of industrial regulation is on the economic performance of natural monopoly or with large firms in a concentrated industry. The major concerns of industrial regulation are with product prices and with the effects of business practices on competition and output. This type of regulation has the longest history in the United States.

Examples of Federal regulatory commissions include: (a) the former Interstate Commerce Commission that regulated such transportation industries as railroads, trucking, water, and shipping; (b) the Federal Energy Regulatory Commission that has jurisdiction over energy industries involved in electricity, gas, gas pipelines, oil pipelines, and water power; and (c) the Federal Communications Commission that regulates such industries as telephones, television, and radio.

In contrast, social regulation is concerned with the production of goods, the conditions under which goods are produced and their effects on society, and with the characteristics of the goods. This type of regulation affects all industries, whether concentrated or highly competitive. This regulation also involves more direct government intervention into the production and distribution of goods and services.

Examples of social regulation include: (a) the Food and Drug Administration that monitors the safety and effectiveness of food, drugs, and cosmetics; (b) the Equal Employment Opportunity Commission that regulates practices in the hiring, promotion, and discharge of workers; (c) the Occupational Safety and Health Administration that has jurisdiction over industrial health and safety; (d) the Environmental Protection Agency that regulates actions affecting air, water, and noise pollution; and (e) the Consumer Product Safety Commission that monitors the safety of consumer products. [text: E pp. 639, 642-643; MI pp. 639, 384-385]

464

review questions & answers micro all chapters-1

Documents