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Instructor's Manual with Solutions Manual
Principles of Microeconomics
FOURTH EDITION
PMG
N. Gregory Mankiw
Harvard University
Prepared by
Linda Ghent
Eastern Illinois University
Instructor’s Manual
th
Principles of Microeconomics, 4 Edition
N. Gregory Mankiw
Prepared by Linda S. Ghent
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Preface
The instructor’s material that accompanies the five versions of Mankiw’s Principles of
Economics, Fourth Edition textbooks address the needs of both novice and experienced
instructors. To meet the needs of these two groups, this Instructor’s Manual with
Solutions Manual comprises both chapter outlines and teaching tips as well as solutions
to all of the questions and problems found in the textbook.
Linda Ghent of Eastern Illinois University prepared the main portion of each chapter
including a synopsis of what is new in this edition compared to the third edition. Her
work for each chapter also includes a list of learning objectives and key points. These
items are followed by detailed chapter outlines that focus on the content found in the
textbook. Helpful tips and icons occasionally interrupt these outlines. The bomb icon
(Warnings) indicates areas where students may have particular difficulty with the
material. The light bulb icon (Bright Ideas) offers ideas for presenting the material in a
new or more thoughtful way. Also included in each chapter of the Instructor’s Manual
are classroom activities, developed in part by Charles Stull of Kalamazoo College. Each
activity provides important details to assist in planning as well as clear instructions for
leading the activity. Recommended “Points for Discussion” connect the activity to the
relevant economic concepts discussed in the chapter.
Using these resources, an instructor can quickly review the chapter learning objectives
and chapter summaries to make sure their lecture notes cover everything in the text
chapter. In addition, the chapter outlines are designed as a base for creating lecture
notes for novice instructors. They may also be used as a complete set of notes for more
experienced instructors. Therefore, this supplement is also available electronically from
the product support Web site (http://mankiw.swlearning.com).
For queries and grading, the Instructor’s Manual contains solutions to exercises from
the textbook. Dean Croushore (University of Richmond) prepared many of the solutions
for the “Quick Quizzes,” “ Questions for Review,” and “Problems and Applications”
found in the textbook.
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Comparative Table of Contents
Core
Part 1: Introduction
1 Ten Principles of Economics
2 Thinking Like an Economist
3 Interdependence and the Gains from Trade
Part 2: How Markets Work
4 The Market Forces of Supply and Demand
5 Elasticity and Its Application
6 Supply, Demand, and Government Policies
Part 3: Markets and Welfare
7 Consumers, Producers, and the Efficiency of Markets
8 Application: The Costs of Taxation
9 Application: International Trade
Part 4: The Economics of the Public Sector
10 Externalities
11 Public Goods and Common Resources
12 The Design of the Tax System
Part 5: Firm Behavior and the Organization of Industry
13 The Costs of Production
14 Firms in Competitive Markets
15 Monopoly
16 Oligopoly
17 Monopolistic Competition
Part 6: The Economics of Labor Market
18 The Markets for the Factors of Production
19 Earnings and Discrimination
20 Income Inequality and Poverty
Part 7: Topics for Further Study
21 The Theory of Consumer Choice
22 Frontiers of Microeconomics
Part 8: The Data of Macroeconomics
23 Measuring a Nation’s Income
24 Measuring the Cost of Living
Part 9: The Real Economy in the Long Run
25 Production and Growth
26 Saving, Investment, and the Financial System
27 The Basic Tools of Finance
28 Unemployment
Part 10: Money and Prices in the Long Run
29 The Monetary System
30 Money Growth and Inflation
Part 11: The Macroeconomics of Open Economics
31 Open-Economy Macroeconomics: Basic Concepts
32 A Macroeconomic Theory of the Open Economy
Part 12: Short-Run Economic Fluctuations
33 Aggregate Demand and Aggregate Supply
34 The Influence of Monetary and Fiscal Policy on Aggregate Demand
35 The Short-Run Trade-off between Inflation and Unemployment
Part 13: Final Thoughts
36 Five Debates over Macroeconomic Policy
Micro
Part 1
1
2
3
Part 2
4
5
6
Part 3
7
8
9
Part 4
10
11
12
Part 5
13
14
15
16
17
Part 6
18
19
20
Part 7
21
22
Macro
Part 1
1
2
3
Part 2
4
5
6
Part 3
7
8
9
Essentials
Part 1
1
2
3
Part 2
4
5
6
Part 3
7
8
9
Part 4
10
11
Brief
Macro
Part 1
1
2
3
Part 2
4
Part 5
12
13
14
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Part 4
10
11
Part 5
12
13
14
15
Part 6
16
17
Part 7
18
19
Part 8
20
21
22
Part 9
23
Part 6
15
16
Part 7
17
18
19
20
Part 8
21
22
Part 9
23
24
Part 3
5
6
Part 4
7
8
9
10
Part 5
11
12
Part 6
13
14
Part 7
15
16
17
Part 8
18
Contents
Chapter 1 Ten Principles of Economics
1
Chapter 2 Thinking Like an Economist
17
Chapter 3 Interdependence and the Gains from Trade
37
Chapter 4 The Market Forces of Supply and Demand
53
Chapter 5 Elasticity and Its Application
91
Chapter 6 Supply, Demand, and Government Policies
111
Chapter 7 Consumers, Producers, and the Efficiency of Markets
131
Chapter 8 Application: The Costs of Taxation
155
Chapter 9 Application: International Trade
175
Chapter 10 Externalities
197
Chapter 11 Public Goods and Common Resources
215
Chapter 12 The Design of the Tax System
227
Chapter 13 The Costs of Production
243
Chapter 14 Firms in Competitive Markets
265
Chapter 15 Monopoly
289
Chapter 16 Oligopoly
315
Chapter 17 Monopolistic Competition
335
Chapter 18 The Markets for the Factors of Production
351
Chapter 19 Earnings and Discrimination
371
Chapter 20 Income Inequality and Poverty
383
Chapter 21 The Theory of Consumer Choice
395
Chapter 22 Frontiers of Microeconomics
425
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1
TEN PRINCIPLES OF ECONOMICS
WHAT’S NEW IN THE FOURTH EDITION:
The discussion of Principle #3, “Rational people think at the margin,” is more thorough and has a new
example. The discussions of Principle #4, “People respond to incentives,” Principle #7, “Governments
can sometimes improve market outcomes,” and Principle #10, “Society faces a short-run trade-off
between inflation and unemployment” have been clarified. Definitions for the terms “rational,”
“incentives,” and “property rights” have been added.
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LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
¾
that economics is about the allocation of scarce resources.
¾
that individuals face trade-offs.
¾
the meaning of opportunity cost.
¾
how to use marginal reasoning when making decisions.
¾
how incentives affect people’s behavior.
¾
why trade among people or nations can be good for everyone.
¾
why markets are a good, but not perfect, way to allocate resources.
¾
what determines some trends in the overall economy.
CONTEXT AND PURPOSE:
Chapter 1 is the first chapter in a three-chapter section that serves as the introduction to the text.
Chapter 1 introduces ten fundamental principles on which the study of economics is based. In a broad
sense, the rest of the text is an elaboration on these ten principles. Chapter 2 will develop how
economists approach problems while Chapter 3 will explain how individuals and countries gain from
trade.
The purpose of Chapter 1 is to lay out ten economic principles that will serve as building blocks
for the rest of the text. The ten principles can be grouped into three categories: how people make
1
2 ) Chapter 1/Ten Principles of Economics
decisions, how people interact, and how the economy works as a whole. Throughout the text, references
will be made repeatedly to these ten principles.
KEY POINTS:
1. The fundamental lessons about individual decisionmaking are that people face trade-offs among
alternative goals, that the cost of any action is measured in terms of forgone opportunities, that
rational people make decisions by comparing marginal costs and marginal benefits, and that people
change their behavior in response to the incentives they face.
2. The fundamental lessons about interactions among people are that trade can be mutually beneficial,
that markets are usually a good way of coordinating trades among people, and that the government
can potentially improve market outcomes if there is some sort of market failure or if the market
outcome is inequitable.
3. The fundamental lessons about the economy as a whole are that productivity is the ultimate source
of living standards, that money growth is the ultimate source of inflation, and that society faces a
short-run trade-off between inflation and unemployment.
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CHAPTER OUTLINE:
I.
Introduction
Begin by pointing out that economics is a subject that students must confront in their
daily lives. Point out that they already spend a great deal of their time thinking about
economic issues: prices, buying decisions, use of their time, etc.
A.
The word “economy” comes from the Greek word oikonomos meaning “one who
manages a household.”
B.
This makes some sense because in the economy we are faced with many decisions (just
as a household is).
C.
Fundamental economic problem: resources are scarce.
You will want to start the semester by explaining to students that part of learning
economics is understanding a new vocabulary. Economists generally use very precise
(and sometimes different) definitions for words that are commonly used outside of
the economics discipline. Therefore, it will be helpful to students if you follow the
definitions provided in the text as much as possible.
D.
Definition of scarcity: the limited nature of society’s resources.
E.
Definition of economics: the study of how society manages its scarce resources.
Chapter 1/Ten Principles of Economics ) 3
Because most college freshmen and sophomores have limited experiences with
viewing the world from a cause-and-effect perspective, do not underestimate how
challenging these principles will be for the student.
As you discuss the ten principles, make sure that students realize that it is okay if
they do not grasp each of the concepts completely or find each of the arguments
fully convincing. These ideas will be explored more completely throughout the text.
II.
How People Make Decisions
Table 1
A.
Principle #1: People Face Trade-offs
1.
“There is no such thing as a free lunch.” Making decisions requires trading one
goal for another.
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2.
Examples include how students spend their time, how a family decides to spend
its income, how the U.S. government spends tax dollars, and how regulations
may protect the environment at a cost to firm owners.
3.
A special example of a trade-off is the trade-off between efficiency and equity.
4.
B.
a.
Definition of efficiency: the property of society getting the
maximum benefits from its scarce resources.
b.
Definition of equity: the property of distributing economic
prosperity fairly among the members of society.
c.
For example, tax dollars paid by wealthy Americans and then distributed
to those less fortunate may improve equity but lower the return to hard
work and therefore reduce the level of output produced by our
resources.
d.
This implies that the cost of this increased equity is a reduction in the
efficient use of our resources.
Recognizing that trade-offs exist does not indicate what decisions should or will
be made.
Principle #2: The Cost of Something Is What You Give Up to Get It
1.
Making decisions requires individuals to consider the benefits and costs of some
action.
2.
What are the costs of going to college?
4 ) Chapter 1/Ten Principles of Economics
3.
a.
We cannot count room and board (at least all of the cost) because the
student would have to pay for food and shelter even if he was not in
school.
b.
We would want to count the value of the student’s time because he
could be working for pay instead of attending classes and studying.
Definition of opportunity cost: whatever must be given up in order to
obtain some item.
One of the hardest ideas for students to grasp is that “free” things are not truly free.
Thus, you will need to provide students with numerous examples of such “free”
things with hidden costs, especially the value of time.
C.
Principle #3: Rational People Think at the Margin
1.
Economists generally assume that people are rational.
a.
Definition of rational: systematically and purposefully doing the
best you can to achieve your objectives.
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2.
D.
b.
Consumers want to purchase the bundle of goods and services that
allows them the greatest level of satisfaction given their incomes and the
prices they face.
c.
Firms want to produce the level of output that maximizes the profits they
earn.
Many decisions in life involve incremental decisions: Should I remain in school
this semester? Should I take another course this semester? Should I study an
additional hour for tomorrow’s exam?
a.
Definition of marginal changes: small incremental adjustments to
a plan of action.
b.
Example: Suppose that flying a 200-seat plane across the country costs
the airline $100,000, which means that the average cost of each seat is
$500. Suppose that the plane is minutes from departure and a passenger
is willing to pay $300 for a seat. Should the airline sell the seat for $300?
In this case, the marginal cost of an additional passenger is very small.
c.
Another example: Why is water so cheap while diamonds are expensive?
Because water is plentiful, the marginal benefit of an additional cup is
small. Because diamonds are rare, the marginal benefit of an extra
diamond is high.
Principle #4: People Respond to Incentives
1.
Definition of incentive: something that induces a person to act.
2.
Because rational people make decisions by weighing costs and benefits, their
decisions may change in response to incentives.
Chapter 1/Ten Principles of Economics ) 5
a.
When the price of a good rises, consumers will buy less of it because its
cost has risen.
b.
When the price of a good rises, producers will allocate more resources to
the production of the good because the benefit from producing the good
has risen.
3.
Many public policies change the costs and benefits that people face. Sometimes
policymakers fail to understand how policies alter incentives and behavior.
4.
Example: Seat belt laws increase the use of seat belts and lower the incentives
of individuals to drive safely. This leads to an increase in the number of car
accidents. This also leads to an increased risk for pedestrians.
If you include any incentive-based criteria on your syllabus, discuss it now. For
example, if you reward class attendance (or penalize students who do not attend
class), explain to students how this change in the marginal benefit of attending class
(or marginal cost of missing class) can be expected to alter their behavior.
III.
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How People Interact
A.
Principle #5: Trade Can Make Everyone Better Off
1.
Trade is not like a sports competition, where one side gains and the other side
loses.
2.
Consider trade that takes place inside your home. Your family is likely to be
involved in trade with other families on a daily basis. Most families do not build
their own homes, make their own clothes, or grow their own food.
3.
Countries benefit from trading with one another as well.
4.
Trade allows for specialization in products that countries (or families) can do
best.
Activity 1—Getting Dressed in the Global Economy
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
Specialization, interdependence, self-interest, consumer choice,
international trade
None
20 minutes
Works in any class size
Purpose
The advantages of specialization and division of labor are very clear in this example. The
worldwide links of the modern economy are also illustrated. We depend on thousands of
people we don’t know, won’t see, and don’t think of in order to get dressed each morning.
Self-interest follows naturally from interdependence. Wages, profits, and rents give people
the incentive to perform these varied tasks. We depend on them to clothe us and they
depend on our purchases for their incomes.
6 ) Chapter 1/Ten Principles of Economics
Instructions
Ask the class to answer the following questions. Give them time to write an answer to each
question, then discuss their answers before moving on to the next question. The first
question can be answered with a brief phrase. The second question is the core of the
assignment and takes several minutes. Ask them to list as many categories of workers as
possible. The third question introduces demand concepts; most of the determinants of
demand can be introduced during this discussion. For the fourth question, ask the class to
look at the country-of-origin tags sewn in their garments.
1.
2.
3.
4.
Where did your clothes come from?
Who worked to produce your clothes?
What things do you consider when buying a garment?
Where were your clothes produced (what countries)?
Common Answers and Points for Discussion
1.
Where did your clothes come from?
There are many possible ways to answer, but many students will say “the mall” or another
retail outlet. Some may say “a factory,” “a sweatshop,” or “a foreign country.”
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Mention the importance of markets here (this can be emphasized by asking, “Is anyone
wearing something made by themselves, a friend, or a relative?”) and discuss distribution
versus production.
2.
Who worked to produce your clothes?
There is no end to the possible answers; garment and textile workers are obvious but most
students will also list workers dealing with raw materials, transportation, management,
design, or machinery. Some may think more broadly to investors, road crews, bankers,
engineers, or accountants.
3.
What things do you consider when buying a garment?
Most answers focus on preferences (fit, style, quality, color). Price is cited less frequently. Ask
about the importance of price until someone volunteers that income is important. Prices of
substitute goods should also be discussed. Expectations of price changes may also be
mentioned.
4.
Where were your clothes produced (what countries)?
A large number of countries will be represented, even in small classes. Asia is always well
represented. Latin American and European goods appear in smaller numbers. African
products are conspicuously absent.
This pattern shows the limits of simple explanations such as “cheap labor.” Briefly discuss the
importance of comparative advantage and specialization.
Chapter 1/Ten Principles of Economics ) 7
B.
Principle #6: Markets Are Usually a Good Way to Organize Economic Activity
1.
Many countries that once had centrally planned economies have abandoned this
system and are trying to develop market economies.
2.
Definition of market economy: an economy that allocates resources
through the decentralized decisions of many firms and households as
they interact in markets for goods and services.
3.
Market prices reflect both the value of a product to consumers and the cost of
the resources used to produce it.
Explain to students that when households and firms do what is best for themselves,
they often end up doing what is best for society, as if guided by market forces—or an
invisible hand. Spend some time and emphasize the magic of the market. Use
numerous examples to show students that the market most often allocates resources
to their highest valued use.
4.
When a government interferes in a market and restricts price from adjusting,
household and firm decisions are not based on the proper information. Thus,
these decisions may be inefficient.
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C.
5.
Centrally planned economies have failed because they did not allow the market
to work.
6.
FYI: Adam Smith and the Invisible Hand
a.
Adam Smith’s 1776 work suggested that although individuals are
motivated by self-interest, an invisible hand guides this self-interest into
promoting society’s economic well-being.
b.
Smith’s astute perceptions will be discussed more fully in the chapters to
come.
Principle #7: Governments Can Sometimes Improve Market Outcomes
1.
The invisible hand will only work if the government enforces property rights.
a.
Definition of property rights: the ability of an individual to own
and exercise control over scarce resources.
2.
There are two broad reasons for the government to interfere with the economy:
the promotion of efficiency and equity.
3.
Government policy can be most useful when there is market failure.
a.
Definition of market failure: a situation in which a market left on
its own fails to allocate resources efficiently.
8 ) Chapter 1/Ten Principles of Economics
4.
5.
IV.
Examples of Market Failure
a.
Definition of externality: the impact of one person’s actions on
the well-being of a bystander.
b.
Definition of market power: the ability of a single economic actor
(or small group of actors) to have a substantial influence on
market prices.
c.
Because a market economy rewards people for their ability to produce
things that other people are willing to pay for, there will be an unequal
distribution of economic prosperity.
Note that the principle states that the government can improve market
outcomes. This is not saying that the government always does improve market
outcomes.
How the Economy as a Whole Works
A.
Principle #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and
Services
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B.
C.
1.
Differences in living standards from one country to another are quite large.
2.
Changes in living standards over time are also great.
3.
The explanation for differences in living standards lies in differences in
productivity.
4.
Definition of productivity: the quantity of goods and services produced
from each hour of a worker’s time.
5.
High productivity implies a high standard of living.
6.
Thus, policymakers must understand the impact of any policy on our ability to
produce goods and services.
Principle #9: Prices Rise When the Government Prints Too Much Money
1.
Definition of inflation: an increase in the overall level of prices in the
economy.
2.
When the government creates a large amount of money, the value of money
falls.
3.
Examples: Germany after World War I (in the early 1920s) and the United States
in the 1970s.
Principle #10: Society Faces a Short-Run Trade-off between Inflation and Unemployment
1.
Most economists believe that the short-run effect of a monetary injection is lower
unemployment and higher prices.
Chapter 1/Ten Principles of Economics ) 9
D.
a.
An increase in the amount of money in the economy stimulates spending
and increases the quantity of goods and services sold in the economy.
The increase in the quantity of goods and services sold will cause firms
to hire additional workers.
b.
An increase in the demand for goods and services leads to higher prices
over time.
2.
Some economists question whether this relationship still exists.
3.
The short-run trade-off between inflation and unemployment plays a key role in
the analysis of the business cycle.
4.
Definition of business cycle: fluctuations in economic activity, such as
employment and production.
5.
Policymakers can exploit this trade-off by using various policy instruments, but
the extent and desirability of these interventions is a subject of continuing
debate.
FYI: How to Read this Book
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1.
Economics is very useful to understand, but it can be a difficult subject to grasp.
2.
There are five tips to make reading and understanding the material in
the book easier.
a.
Summarize, don’t highlight.
b.
Test yourself. At the end of each section of the text, you will find a
“Quick Quiz.” Answers to these “Quick Quizzes” can be found in the back
of this textbook.
c.
Practice, practice, practice.
d.
Go online and use the website for this text.
e.
Study in groups.
f.
Don’t forget the real world.
10 ) Chapter 1/Ten Principles of Economics
Activity 2—So Many Things to Do, So Little Time
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
Trade-offs, opportunity cost, thinking at the margin, incentives
None
10 minutes
Works in any class size
Give students a list of activities with corresponding time requirements: sleep, 8 hours; sleep,
6 hours; eat breakfast, 30 minutes; ride a bike, 1 hour; go hiking, 2 hours; study, 3 hours;
study, 2 hours; go to class, 4 hours; go to class, 6 hours; watch TV, 2 hours; watch TV, 6
hours; take a nap, 1 hour; work, 8 hours; work, 4 hours; etc.
Make sure that there are many choices and that there are many pleasurable experiences—too
much for a 24-hour period.
Ask students which Principle of Economics this illustrates.
If they do not say 1, 2, 3, and 4, help them see that this exercise has trade-offs in the choices
they make, that each choice has an opportunity cost, that deciding whether or not to sleep 4
more hours may depend on whether you have already slept for 6, and that choices may be
influenced by the incentives the student faces. For example, a student who is about to be
placed on academic probation has an incentive to study harder.
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SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
The four principles of economic decision making are: (1) people face trade-offs; (2) the cost of
something is what you give up to get it; (3) rational people think at the margin; and (4) people
respond to incentives. People face trade-offs because to get one thing that they like, they
usually have to give up another thing that they like. The cost of something is what you give up
to get it, not just in terms of monetary costs but all opportunity costs. Rational people think at
the margin by taking an action if and only if the marginal benefit exceeds the marginal cost.
People respond to incentives because they choose activities by comparing benefits to costs;
therefore, a change in these benefits or costs may cause their behavior to change.
2.
The three principles concerning people’s economic interactions are: (1) trade can make everyone
better off; (2) markets are usually a good way to organize economic activity; and (3)
governments can sometimes improve market outcomes. Trade can make everyone better off
because it allows countries to specialize in what they do best and to enjoy a wider variety of
goods and services. Markets are usually a good way to organize economic activity because the
invisible hand leads markets to desirable outcomes. Governments can sometimes improve
market outcomes because markets may fail to allocate resources efficiently due to an externality
or market power.
Chapter 1/Ten Principles of Economics ) 11
3.
The three principles that describe how the economy as a whole works are: (1) a country’s
standard of living depends on its ability to produce goods and services; (2) prices rise when the
government prints too much money; and (3) society faces a short-run trade-off between inflation
and unemployment. A country’s standard of living depends largely on the productivity of its
workers, which in turn depends on the education of its workers and the access its workers have
to the necessary tools and technology. Prices rise when the government prints too much money
because more money in circulation reduces the value of money, causing inflation. Society faces
a short-run trade-off between inflation and unemployment that is only temporary. Policymakers
have some short-term ability to exploit this relationship using various policy instruments.
Questions for Review
1.
Examples of trade-offs include time trade-offs (such as studying one subject over another or
studying at all compared to engaging in social activities) and spending trade-offs (such as
whether to use your last 15 dollars to purchase a pizza or to buy a study guide for that tough
economics course).
2.
The opportunity cost of seeing a movie includes the monetary cost of admission plus the time
cost of going to the theater and attending the show. The time cost depends on what else you
might do with that time; if it is staying home and watching TV, the time cost may be small, but if
it is working an extra three hours at your job, the time cost is the money you could have earned.
3.
4.
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The marginal benefit of a glass of water depends on your circumstances. If you have just run a
marathon or you have been walking in the desert sun for three hours, the marginal benefit is
very high. But if you have been drinking a lot of liquids recently, the marginal benefit is quite low.
The point is that even the necessities of life, like water, do not always have large marginal
benefits.
Policymakers need to think about incentives so they can understand how people will respond to
the policies they put in place. The text's example of seat belt laws shows that policy actions can
have unintended consequences. If incentives matter a lot, they may lead to a very different type
of policy; for example, some economists have suggested putting knives in steering columns so
that people will drive much more carefully! While this suggestion is silly, it highlights the
importance of incentives.
5.
Trade among countries is not a game with some losers and some winners because trade can
make everyone better off. By allowing specialization, trade between people and trade between
countries can improve everyone's welfare.
6.
The "invisible hand" of the marketplace represents the idea that even though individuals and
firms are all acting in their own self-interest, prices and the marketplace guide them to do what is
good for society as a whole.
7.
The two main causes of market failure are externalities and market power. An externality is the
impact of one person’s actions on the well-being of a bystander, such as from pollution or the
creation of knowledge. Market power refers to the ability of a single person (or small group of
people) to unduly influence market prices, such as in a town with only one well or only one cable
television company. In addition, a market economy also leads to an unequal distribution of
income.
12 ) Chapter 1/Ten Principles of Economics
8.
Productivity is important because a country's standard of living depends on its ability to produce
goods and services. The greater a country's productivity (the amount of goods and services
produced from each hour of a worker's time), the greater its standard of living will be.
9.
Inflation is an increase in the overall level of prices in the economy. Inflation is caused by
increases in the quantity of a nation's money.
10.
Inflation and unemployment are negatively related in the short run. Thus, reducing inflation
entails costs to society in the form of higher unemployment in the short run.
Problems and Applications
1.
a.
A family deciding whether to buy a new car faces a trade-off between the cost of the car
and other things they might want to buy. For example, buying the car might mean they
must give up going on vacation for the next two years. So the real cost of the car is the
family's opportunity cost in terms of what they must give up.
b.
For a member of Congress deciding whether to increase spending on national parks, the
trade-off is between parks and other spending items or tax cuts. If more money goes
into the park system, that may mean less spending on national defense or on the police
force. Or, instead of spending more money on the park system, taxes could be reduced.
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c.
When a company president decides whether to open a new factory, the decision is based
on whether the new factory will increase the firm's profits compared to other
alternatives. For example, the company could upgrade existing equipment or expand
existing factories. The bottom line is: Which method of expanding production will
increase profit the most?
d.
In deciding how much to prepare for class, a professor faces a trade-off between the
value of improving the quality of the lecture compared to other things she could do with
her time, such as working on additional research.
2.
When the benefits of something are psychological, such as going on a vacation, it is not easy to
compare benefits to costs to determine if it is worth doing. But there are two ways to think about
the benefits. One is to compare the vacation with what you would do in its place. If you did not
go on vacation, would you buy something like a new set of golf clubs? Then you can decide if
you would rather have the new clubs or the vacation. A second way is to think about how hard
you had to work to earn the money to pay for the vacation. You can then decide if the
psychological benefits of the vacation were worth the psychological cost of working.
3.
If you are thinking of going skiing instead of working at your part-time job, the cost of skiing
includes its monetary and time costs, which includes the opportunity cost of the wages you are
giving up by not working. If the choice is between skiing and going to the library to study, then
the cost of skiing is its monetary and time costs including the cost of getting lower grades in your
courses.
4.
If you spend $100 now instead of saving it for a year and earning 5 percent interest, you are
giving up the opportunity to spend $105 a year from now.
5.
The fact that you have already sunk $5 million is not relevant to your decision anymore, because
that money is gone. What matters now is the chance to earn profits at the margin. If you spend
another $1 million and can generate sales of $3 million, you'll earn $2 million in marginal profit,
Chapter 1/Ten Principles of Economics ) 13
so you should do so. You are right to think that the project has lost a total of $3 million ($6
million in costs and only $3 million in revenue) and you should not have started it. That is true,
but if you do not spend the additional $1 million, you will not have any sales and your losses will
be $5 million. So what matters is not the total profit, but the profit you can earn at the margin.
In fact, you wouldd pay up to $3 million to complete development; any more than that, and you
will not be increasing profit at the margin.
6.
Harry suggests looking at whether productivity would rise or fall. Productivity is certainly
important, since the more productive workers are, the lower the cost per gallon of potion. Ron
wants to look at average cost. But both Harry and Ron are missing the other side of the
equation⎯revenue. A firm wants to maximize its profits, so it needs to examine both costs and
revenues. Thus, Hermione is right⎯it is best to examine whether the extra revenue would
exceed the extra costs. Hermione is the only one who is thinking at the margin.
7.
a.
The provision of Social Security benefits lowers an individual’s incentive to save for
retirement. The benefits provide some level of income to the individual when he or she
retires. This means that the individual is not entirely dependent on savings to support
consumption through the years in retirement.
b.
Since a person gets fewer after-tax Social Security benefits the greater his or her
earnings are, there is an incentive not to work (or not work as much) after age 65. The
more you work, the lower your after-tax Social Security benefits will be. Thus, the
taxation of Social Security benefits discourages work effort after age 65.
8.
9.
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a.
When welfare recipients have their benefits cut off after two years, they have a greater
incentive to find jobs than if their benefits were to last forever.
b.
The loss of benefits means that someone who cannot find a job will get no income at all,
so the distribution of income will become less equal. But the economy will be more
efficient, because welfare recipients have a greater incentive to find jobs. Thus, the
change in the law is one that increases efficiency but reduces equity.
By specializing in each task, you and your roommate can finish the chores more quickly. If you
divided each task equally, it would take you more time to cook than it would take your
roommate, and it would take him more time to clean than it would take you. By specializing, you
reduce the total time spent on chores.
Similarly, countries can specialize and trade, making both better off. For example, suppose it
takes Spanish workers less time to make clothes than French workers, and French workers can
make wine more efficiently than Spanish workers. Then Spain and France can both benefit if
Spanish workers produce all the clothes and French workers produce all the wine, and they
exchange wine for clothes.
10.
a.
To produce the right number of CDs by the right artists and deliver them to the right
people requires an enormous amount of information. You need to know about production
techniques and costs in the CD industry. You need to know each person's musical tastes
and which artists they want to hear. If you make the wrong decisions, you will be
producing too many CDs by artists that people do not want to hear, and not enough by
others.
b.
Your decisions about CDs will carry over to other decisions. You have to make the right
number of CD players for people to use. If you make too many CDs and not enough
cassette tapes, people with cassette players will be stuck with CDs they cannot play. The
14 ) Chapter 1/Ten Principles of Economics
probability of making mistakes is very high. You will also be faced with tough choices
about the music industry compared to other parts of the economy. If you produce more
sports equipment, you will have fewer resources for making CDs. So all decisions about
the economy influence your decisions about CD production.
11.
Countries that have corrupt police and court systems do not enforce individual property rights,
including the rights over the goods and services produced by households and firms. Firms will not
choose to produce products and individuals will choose not to work if there is no guarantee that
they will receive payment for their efforts. Therefore, these countries end up with a lower
standard of living.
12.
a.
b.
c.
d.
e.
f.
Efficiency: The market failure comes from the market power of the cable TV firm.
Equity
Efficiency: An externality arises because secondhand smoke harms nonsmokers.
Efficiency: The market failure occurs because of Standard Oil's market power.
Equity
Efficiency: There is an externality because of accidents caused by drunk drivers.
13.
a.
If everyone were guaranteed the best health care possible, much more of our nation's
output would be devoted to medical care than is now the case. Would that be efficient?
If you believe that doctors have market power and restrict health care to keep their
incomes high, you might think efficiency would increase by providing more health care.
But more likely, if the government mandated increased spending on health care, the
economy would be less efficient because it would give people more health care than they
would choose to pay for. From the point of view of equity, if poor people are less likely to
have adequate health care, providing more health care would represent an improvement.
Each person would have a more even slice of the economic pie, though the pie would
consist of more health care and less of other goods.
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b.
When workers are laid off, equity considerations argue for the unemployment benefits
system to provide them with some income until they can find new jobs. After all, no one
plans to be laid off, so unemployment benefits are a form of insurance. But there is an
efficiency problem⎯why work if you can get income for doing nothing? The economy is
not operating efficiently if people remain unemployed for a long time, and unemployment
benefits encourage unemployment. Thus, there is a trade-off between equity and
efficiency. The more generous unemployment benefits are, the less income is lost by an
unemployed person, but the more that person is encouraged to remain unemployed. So
greater equity reduces efficiency.
14.
Because average income in the United States has roughly doubled every 35 years, we are likely
to have a better standard of living than our parents, and a much better standard of living than
our grandparents. This is mainly the result of increased productivity, so that an hour of work
produces more goods and services than it used to. Thus, incomes have continuously risen over
time, as has the standard of living.
15.
If Americans save more and it leads to more spending on factories, there will be an increase in
production and productivity, because the same number of workers will have more equipment to
work with. The benefits from higher productivity will go to both the workers, who will get paid
more because they are producing more, and the factory owners, who will get a return on their
investments. There is no such thing as a free lunch, however, because when people save more,
they are giving up spending. They get higher incomes at the cost of buying fewer goods.
Chapter 1/Ten Principles of Economics ) 15
16.
To make an intelligent decision about whether to reduce inflation, a policymaker would need to
know what causes inflation and unemployment, as well as what determines the trade-off
between them. This means that the policymaker needs to understand how households and firms
will adjust to a decrease in the money supply. How much will spending decline? How much will
firms lower output? Any attempt to reduce inflation will likely lead to higher unemployment in the
short run. A policymaker thus faces a trade-off between the benefits of lower inflation compared
to the cost of higher unemployment.
17.
Answers will vary.
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2
THINKING LIKE AN ECONOMIST
WHAT’S NEW IN THE FOURTH EDITION:
The presentation of the production possibilities frontier has been extensively rewritten and augmented.
There is a new FYI box on “Who Studies Economics?” There is a new In the News feature on “Superbowl
Economics.” There is also a new Case Study about Greg Mankiw’s job as the chairman of the Council of
Economic Advisers.
LEARNING OBJECTIVES:
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By the end of this chapter, students should understand:
¾
how economists apply the methods of science.
¾
how assumptions and models can shed light on the world.
¾
two simple models—the circular flow and the production possibilities frontier.
¾
the difference between microeconomics and macroeconomics.
¾
the difference between positive and normative statements.
¾
the role of economists in making policy.
¾
why economists sometimes disagree with one another.
CONTEXT AND PURPOSE:
Chapter 2 is the second chapter in a three chapter section that serves as the introduction of the text.
Chapter 1 introduced ten principles of economics that will be revisited throughout the text. Chapter 2
develops how economists approach problems while Chapter 3 will explain how individuals and countries
gain from trade.
The purpose of Chapter 2 is to familiarize students with how economists approach economic
problems. With practice, they will learn how to approach similar problems in this dispassionate systematic
way. They will see how economists employ the scientific method, the role of assumptions in model
building, and the application of two specific economic models. Students will also learn the important
distinction between two roles economists can play: as scientists when we try to explain the economic
world and as policymakers when we try to improve it.
17
18 ) Chapter 2/Thinking Like an Economist
KEY POINTS:
1. Economists try to address their subject with a scientist’s objectivity. Like all scientists, they make
appropriate assumptions and build simplified models in order to understand the world around them.
Two simple economic models are the circular-flow diagram and the production possibilities frontier.
2. The field of economics is divided into two subfields: microeconomics and macroeconomics.
Microeconomists study decisionmaking by households and firms and the interaction among
households and firms in the marketplace. Macroeconomists study the forces and trends that affect
the economy as a whole.
3. A positive statement is an assertion about how the world is. A normative statement is an assertion
about how the world ought to be. When economists make normative statements, they are acting
more as policy advisers than scientists.
4. Economists who advise policymakers offer conflicting advice either because of differences in scientific
judgments or because of differences in values. At other times, economists are united in the advice
they offer, but policymakers may choose to ignore it.
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CHAPTER OUTLINE:
I.
The Economist as Scientist
A.
B.
Economists follow the scientific method.
1.
Observations help us to develop theory.
2.
Data can be collected and analyzed to evaluate theories.
3.
Using data to evaluate theories is more difficult in economics than in physical
science because economists are unable to generate their own data and must
make do with whatever data are available.
4.
Thus, economists pay close attention to the natural experiments offered by
history.
Assumptions make the world easier to understand.
1.
Example: to understand international trade, it may be helpful to start out
assuming that there are only two countries in the world producing only two
goods. Once we understand how trade would work between these two
countries, we can extend our analysis to a greater number of countries and
goods.
2.
One important role of a scientist is to understand which assumptions one should
make.
3.
Economists often use assumptions that are somewhat unrealistic but will have
small effects on the actual outcome of the answer.
Chapter 2/Thinking Like an Economist ) 19
C.
Economists use economic models to explain the world around us.
To illustrate to the class how simple but unrealistic models can be useful, bring a
road map to class. Point out how unrealistic it is. For example, it does not show
where all of the stop signs, gas stations, or restaurants are located. It assumes that
the earth is flat and two-dimensional. But, despite these simplifications, a map
usually helps travelers get from one place to another. Thus, it is a good model.
1.
Most economic models are composed of diagrams and equations.
2.
The goal of a model is to simplify reality in order to increase our understanding.
This is where the use of assumptions is helpful.
Activity 1 — Realism and Models: An Analogy
Type:
Topics:
Materials needed:
In-class demonstration
Models
Airplane kit, sheet of paper, whirl-a-gig wing toy (Note: the whirl-agig wing toy is a helicopter wing on a stick; it is often sold in museum
gift shops as well as toy stores.)
5 minutes
Works in any class size
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Time:
Class limitations:
Ask the class if a realistic model is better than an unrealistic model.
Show them the airplane model kit. Describe some of the details included in model (rivets,
canopy, struts, etc.). Shake the box to rattle the large number of parts. This is a fairly
realistic model, although obviously not a real airplane. Its complexity adds realism, but at a
cost; assembling the model is very time consuming. Drop the box on the floor. Tell the class,
“This model, even when completed, cannot fly.”
Take a sheet of paper and fold it into a paper airplane. Show the class this new model. Its
virtues include simplicity and ease of assembly, but it is less realistic than the airplane model
kit. Throw the airplane and explain, “While less detailed, this model can glide through the
air.”
Show the students the whirl-a-gig wing toy. This model looks nothing like an airplane – just a
T-shaped piece of wood. Yet, this model does something that the other two models cannot
do: it actually generates lift. This toy demonstrates the same aerodynamic principles as a real
airplane wing. Twirl the stick between your palms and the whirl-a-gig wing toy will fly over
your head.
Economic models are like the whirl-a-gig wing toy. They are much less complex than the real
world, but they can show how markets actually work.
20 ) Chapter 2/Thinking Like an Economist
D.
Our First Model: The Circular Flow Diagram
Figure 1
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1.
Definition of circular-flow diagram: a visual model of the economy that
shows how dollars flow through markets among households and firms.
2.
This diagram is a very simple model of the economy. Note that it ignores the
roles of government and international trade.
a.
There are two decision makers in the model: households and firms.
b.
There are two markets: the market for goods and services and the
market of factors of production.
c.
Firms are sellers in the market for goods and services and buyers in the
market for factors of production.
Chapter 2/Thinking Like an Economist ) 21
E.
d.
Households are buyers in the market for goods and services and sellers
in the market for factors of production.
e.
The inner loop represents the flows of inputs and outputs between
households and firms.
f.
The outer loop represents the flows of dollars between households and
firms.
Our Second Model: The Production Possibilities Frontier
1.
Definition of production possibilities frontier: a graph that shows the
combinations of output that the economy can possibly produce given
the available factors of production and the available production
technology.
Spend more time with this model than you think is necessary. Be aware that the
math skills of many of your students will be limited. It is important for the students
to feel confident with this first graphical and mathematical model. Be deliberate with
every point. If you lose them with this model, they may be gone for the rest of the
course.
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2.
Example: an economy that produces two goods, cars and computers.
Figure 2
a.
If all resources are devoted to producing cars, the economy would
produce 1,000 cars and zero computers.
b.
If all resources are devoted to producing computers, the economy would
produce 3,000 computers and zero cars.
c.
More likely, the resources will be divided between the two industries.
The feasible combinations of output are shown on the production
possibilities frontier.
ALTERNATIVE CLASSROOM EXAMPLE:
A small country produces two goods: corn (measured in bushels) and trucks. Points on a
production possibilities frontier can be shown in a table or a graph:
Trucks
Corn
A
B
C
D
E
0
70
10
60
20
45
30
25
40
0
The production possibilities frontier should be drawn from the numbers above.
Students should be asked to calculate the opportunity cost of increasing the number of trucks
produced by ten:
• between 0 and 10
• between 10 and 20
• between 20 and 30
• between 30 and 40
22 ) Chapter 2/Thinking Like an Economist
Quantity of
Computers
Produced
C
3,000
A
2,200
2,000
B
1,000
D
0
300
600 700
1,000
Quantity of
Cars Produced
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You may want to include time dimensions for variables to make it clear that the
production data are measured in terms of annual flows. This will help students to
realize that a new production possibilities frontier occurs for each year. Thus, the
axes show the levels of output per year.
It is useful to point out that the production possibilities curve depends on two things:
the availability of resources and the level of technology.
3.
Because resources are scarce, not every combination of computers and cars is
possible. Production at a point outside of the curve (such as C) is not possible
given the economy’s current level of resources and technology.
4.
Production is efficient at points on the curve (such as A and B). This implies that
the economy is getting all it can from the scarce resources it has available.
There is no way to produce more of one good without producing less of another.
5.
Production at a point inside the curve (such as D) is inefficient.
a.
This means that the economy is producing less than it can from the
resources it has available.
b.
If the source of the inefficiency is eliminated, the economy can increase
its production of both goods.
Chapter 2/Thinking Like an Economist ) 23
6.
7.
8.
The production possibilities frontier reveals Principle #1: People face tradeoffs.
a.
Suppose the economy is currently producing 600 cars and 2,200
computers.
b.
To increase the production of cars to 700, the production of computers
must fall to 2,000.
Principle #2 is also shown on the production possibilities frontier: The cost of
something is what you give up to get it (opportunity cost).
a.
The opportunity cost of increasing the production of cars from 600 to
700 is 200 computers.
b.
Thus, the opportunity cost of each car is two computers.
The opportunity cost of a car depends on the number of cars and computers
currently produced by the economy.
a.
The opportunity cost of a car is high when the economy is producing
many cars and few computers.
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b.
9.
The opportunity cost of a car is low when the economy is producing few
cars and many computers.
Economists generally believe that production possibilities frontiers often have this
bowed-out shape because some resources are better suited to the production of
cars than computers (and vice versa).
Be aware that students often have trouble understanding why opportunity costs rise
as the production of a good increases. You may want to use several specific
examples of resources that are more suited to producing cars than computers (e.g.,
an experienced mechanic) as well as examples of resources that are more suited to
producing computers than cars (e.g., an experienced computer programmer).
10.
The production possibilities frontier can shift if resource availability or technology
changes. Economic growth can be illustrated by an outward shift of the
production possibilities frontier.
Figure 3
You may also want to teach students about budget constraints at this time (call them
“consumption possibilities frontiers”). This reinforces the idea of opportunity cost,
and allows them to see how opportunity cost can be measured by the slope. Also, it
will introduce students to the use of a straight-line production possibilities frontier
(which is used in Chapter 3). However, be careful if you choose to do this as
students often find the difference between straight-line and concave production
possibilities frontiers challenging.
24 ) Chapter 2/Thinking Like an Economist
ALTERNATIVE CLASSROOM EXAMPLE:
Ivan receives an allowance from his parents of $10 each week. He spends his entire
allowance on two goods: ice cream cones (which cost $1 each) and tickets to the movies
(which cost $5 each).
Students should be asked to calculate the opportunity cost of one movie and the opportunity
cost of one ice cream cone.
Ivan’s consumption possibilities frontier (budget constraint) can be drawn. It should be
noted that the slope is equal to the opportunity cost and is constant because the opportunity
cost is constant.
Ask students what would happen to the consumption possibilities frontier if Ivan’s allowance
changes or if the price of ice cream cones or movies changes.
F.
Microeconomics and Macroeconomics
1.
Economics is studied on various levels.
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G.
II.
a.
Definition of microeconomics: the study of how households and
firms make decisions and how they interact in markets.
b.
Definition of macroeconomics: the study of economy-wide
phenomena, including inflation, unemployment, and economic
growth.
2.
Microeconomics and macroeconomics are closely intertwined because changes in
the overall economy arise from the decisions of individual households and firms.
3.
Because microeconomics and macroeconomics address different questions, each
field has its own set of models which are often taught in separate courses.
FYI: Who Studies Economics?
1.
Economics can seem abstract at first, but it is fundamentally very practical and
the study of economics is useful in many different career paths.
2.
This box provides a sample of well-known individuals who majored in economics
in college.
The Economist as Policy Adviser
A.
Positive Versus Normative Analysis
1.
Example of a discussion of minimum-wage laws: Polly says, “Minimum-wage
laws cause unemployment.” Norma says, “The government should raise the
minimum wage.”
2.
Definition of positive statements: claims that attempt to describe the
world as it is.
Chapter 2/Thinking Like an Economist ) 25
3.
Definition of normative statements: claims that attempt to prescribe
how the world should be.
4.
Positive statements can be evaluated by examining data, while normative
statements involve personal viewpoints.
5.
Positive views about how the world works affect normative views about which
policies are desirable.
Use several examples to illustrate the differences between positive and normative
statements and stimulate classroom discussion. Possible examples include the
minimum wage, budget deficits, tobacco taxes, legalization of marijuana, and seatbelt laws.
Have students bring in newspaper articles and in groups, identify each statement in
an editorial paragraph as being a positive or normative statement. Discuss the
difference between straight news stories and editorials and the analogy to
economists as scientists and as policy advisers.
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B.
6.
Much of economics is positive; it tries to explain how the economy works. But
those who use economics often have goals that are normative. They want to
understand how to improve the economy.
7.
In the News: Superbowl Economics
a.
Economists often offer advice to policymakers (including football
coaches).
b.
This is an article from The New York Times that describes how Bill
Belichick, the coach of the New England Patriots, uses economic analysis
to enhance his team’s performance.
Economists in Washington
1.
Economists are aware that tradeoffs are involved in most policy decisions.
2.
The president receives advice from the Council of Economic Advisers (created in
1946).
3.
Economists are also employed by administrative departments within the various
federal agencies such as the Department of Treasury, the Department of Labor,
the Congressional Budget Office, and the Federal Reserve. Table 1 lists the
World Wide Web addresses of these agencies.
Table 1
4.
The research and writings of economists can also indirectly affect public policy.
26 ) Chapter 2/Thinking Like an Economist
5.
Case Study: Mr. Mankiw Goes to Washington
a.
III.
From 2003 to 2005, the author of this textbook was the chairman of the
Council of Economic Advisers.
Why Economists Disagree
A.
B.
Differences in Scientific Judgments
1.
Economists often disagree about the validity of alternative theories or about the
size of the effects of changes in the economy on the behavior of households and
firms.
2.
Example: some economists feel that a change in the tax code that would
eliminate a tax on income and create a tax on consumption would increase
saving in this country. However, other economists feel that the change in the
tax system would have little effect on saving behavior and therefore do not
support the change.
Differences in Values
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C.
Perception Versus Reality
1.
While it seems as if economists do not agree on much, this is in fact not true.
Table 2 contains ten propositions that are endorsed by a majority of economists.
Table 2
Emphasize that there is more agreement among economists than most people think.
The reason for this is probably that the things that are generally agreed upon are
boring to most noneconomists.
IV.
2.
Almost all economists believe that rent control adversely affects the availability
and quality of housing.
3.
While most economists oppose barriers to trade, the Bush Administration
imposed temporary tariffs on steel in 2002.
In the News: Why You Should Study Economics
A.
Training in economics helps us to understand fallacies and to anticipate unintended
consequences.
B.
This is an excerpt from a commencement address by Robert D. McTeer, Jr., the former
President of the Federal Reserve Bank of Dallas that describes why students should study
economics.
Chapter 2/Thinking Like an Economist ) 27
V.
Appendix—Graphing: A Brief Review
Many instructors may be unaware of how much trouble beginning students have
grasping the most basic graphs. It is important for instructors to make sure that
students are comfortable with these techniques.
When reviewing graphing with the students, it is best to bring students to the board
to be “recorders” of what the other students say as you give a series of instructions
like “Draw a pie chart” or ask questions like “How tall should the bar be if the value is
120 million?” Do not make the student at the board responsible for the answer.
Instead, he or she should be simply recording what the other students say. Students
are often uneasy about graphing at first and need to see that they are not alone.
A.
Graphs of a Single Variable
Figure A-1
1.
Pie Chart
2.
Bar Graph
3.
Time-Series Graph
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B.
Graphs of Two Variables: The Coordinate System
Figure A-2
1.
Economists are often concerned with relationships between two or more
variables.
2.
Ordered pairs of numbers can be graphed on a two-dimensional grid.
a.
The first number in the ordered pair is the x-coordinate and tells us the
horizontal location of the point.
b.
The second number in the ordered pair is the y-coordinate and tells us
the vertical location of the point.
3.
The point with both an x-coordinate and y-coordinate of zero is called the origin.
4.
Two variables that increase or decrease together have a positive correlation.
5.
Two variables that move in opposite directions (one increases when the other
decreases) have a negative correlation.
28 ) Chapter 2/Thinking Like an Economist
C.
Curves in the Coordinate System
1.
Often, economists want to show how one variable affects another, holding all
other variables constant.
Table A-1
Figure A-3
a.
An example of this is a demand curve.
b.
The demand curve shows how the quantity of a good a consumer wants
to purchase varies as its price varies, holding everything else (such as
income) constant.
c.
If income does change, this will alter the amount of a good that the
consumer wants to purchase at any given price. Thus, the relationship
between price and quantity desired has changed and must be
represented as a new demand curve.
Figure A-4
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d.
D.
A simple way to tell if it is necessary to shift the curve is to look at the
axes. When a variable that is not named on either axis changes, the
curve shifts.
Slope
Figure A-5
1.
2.
We may want to ask how strongly a consumer reacts if the price of a product
changes.
a.
If the demand curve is very steep, the quantity desired does not change
much in response to a change in price.
b.
If the demand curve is very flat, the quantity desired changes a great
deal when the price changes.
The slope of a line is the ratio of the vertical distance covered to the horizontal
distance covered as we move along the line (“rise over run”).
slope =
3.
∆y
∆x
A small slope means that the demand curve is relatively flat; a large slope means
that the demand curve is relatively steep.
Chapter 2/Thinking Like an Economist ) 29
E.
Cause and Effect
1.
Economists often make statements suggesting that a change in Variable A
causes a change in Variable B.
2.
Ideally, we would like to see how changes in Variable A affect Variable B, holding
all other variables constant.
3.
This is not always possible and could lead to a problem caused by omitted
variables.
Figure A-6
4.
a.
If Variables A and B both change at the same time, we may conclude
that the change in Variable A caused the change in Variable B.
b.
But, if Variable C has also changed, it is entirely possible that Variable C
is responsible for the change in Variable B.
Another problem is reverse causality.
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Figure A-7
a.
If Variable A and Variable B both change at the same time, we may
believe that the change in Variable A led to the change in Variable B.
b.
However, it is entirely possible that the change in Variable B led to the
change in Variable A.
c.
It is not always as simple as determining which variable changed first
because individuals often change their behavior in response to a change
in their expectations about the future. This means that Variable A may
change before Variable B but only because of the expected change in
Variable B.
There are two very good examples in the text that you should use in class. To
discuss the omitted variable problem, point out to students that a rise in the sales of
cigarette lighters is positively related to the number of individuals diagnosed with
lung cancer. To discuss reverse causality, show that an increase in minivan sales is
followed by an increase in birth rates.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
30 ) Chapter 2/Thinking Like an Economist
1.
Economics is like a science because economists devise theories, collect data, and analyze the
data in an attempt to verify or refute their theories. In other words, economics is based on the
scientific method.
Figure 1 shows the production possibilities frontier for a society that produces food and clothing.
Point A is an efficient point (on the frontier), point B is an inefficient point (inside the frontier),
and point C is an infeasible point (outside the frontier).
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Figure 1
The effects of a drought are shown in Figure 2. The drought reduces the amount of food that
can be produced, shifting the production possibilities frontier inward.
Figure 2
Microeconomics is the study of how households and firms make decisions and how they interact
in markets. Macroeconomics is the study of economy-wide phenomena, including inflation,
unemployment, and economic growth.
Chapter 2/Thinking Like an Economist ) 31
2.
An example of a positive statement is “higher taxes discourage work effort.” It is a positive
statement because it is a claim that describes the world as it is. An example of a normative
statement is “the government should reduce tax rates.” It is a normative statement because it is
a claim that prescribes how the world should be. Many other examples are possible.
Parts of the government that regularly rely on advice from economists are the Department of the
Treasury in designing tax policy, the Department of Labor in analyzing data on the employment
situation, the Department of Justice in enforcing the nation’s antitrust laws, the Congressional
Budget Office in evaluating policy proposals, and the Federal Reserve in analyzing economic
developments. Many other answers are possible.
3.
Economic advisers to the president might disagree about a question of policy because of
differences in scientific judgments or differences in values.
Questions for Review
1.
2.
3.
4.
Economics is like a science because economists use the scientific method. They devise theories,
collect data, and then analyze these data in an attempt to verify or refute their theories about
how the world works. Economists use theory and observation like other scientists, but they are
limited in their ability to run controlled experiments. Instead, they must rely on natural
experiments.
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Economists make assumptions to simplify problems without substantially affecting the answer.
Assumptions can make the world easier to understand.
An economic model cannot describe reality exactly because it would be too complicated to
understand. A model is a simplification that allows the economist to see what is truly important.
Figure 3 shows a production possibilities frontier between milk and cookies (PPF1). If a disease
kills half of the economy's cow population, less milk production is possible, so the PPF shifts
inward (PPF2). Note that if the economy produces all cookies, it does not need any cows and
production is unaffected. But if the economy produces any milk at all, then there will be less
production possible after the disease hits.
Figure 3
32 ) Chapter 2/Thinking Like an Economist
5.
The idea of efficiency is that an outcome is efficient if the economy is getting all it can from the
scarce resources it has available. In terms of the production possibilities frontier, an efficient
point is a point on the frontier, such as point A in Figure 4. When the economy is using its
resources efficiently, it cannot increase the production of one good without reducing the
production of the other. A point inside the frontier, such as point B, is inefficient since more of
one good could be produced without reducing the production of another good.
Figure 4
6.
7.
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The two subfields in economics are microeconomics and macroeconomics. Microeconomics is the
study of how households and firms make decisions and how they interact in specific markets.
Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment,
and economic growth.
Positive statements are descriptive and make a claim about how the world is, while normative
statements are prescriptive and make a claim about how the world ought to be. Here is an
example. Positive: A rapid growth rate of money is the cause of inflation. Normative: The
government should keep the growth rate of money low.
8.
The Council of Economic Advisers is a group of economists who consult with the president of the
United States about economic matters. The Council consists of three members and a staff of
several dozen economists. It writes the annual Economic Report of the President.
9.
Economists sometimes offer conflicting advice to policymakers for two reasons:
(1) economists may disagree about the validity of alternative positive theories about how the
world works; and (2) economists may have different values and, therefore, different normative
views about what public policy should try to accomplish.
Chapter 2/Thinking Like an Economist ) 33
Problems and Applications
1.
See Figure 5; the four transactions are shown.
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Figure 5
2.
a.
Figure 6 shows a production possibilities frontier between guns and butter. It is bowed
out because the opportunity cost of butter depends on how much butter and how many
guns the economy is producing. When the economy is producing a lot of butter, workers
and machines best suited to making guns are being used to make butter, so each unit of
guns given up yields a small increase in the production of butter. Thus, the frontier is
steep and the opportunity cost of producing butter is high. When the economy is
producing a lot of guns, workers and machines best suited to making butter are being
used to make guns, so each unit of guns given up yields a large increase in the
production of butter. Thus, the frontier is very flat and the opportunity cost of producing
butter is low.
34 ) Chapter 2/Thinking Like an Economist
b.
3.
Figure 6
Point A is impossible for the economy to achieve; it is outside the production possibilities
frontier. Point B is feasible but inefficient because it is inside the production possibilities
frontier.
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c.
The Hawks might choose a point like H, with many guns and not much butter. The
Doves might choose a point like D, with a lot of butter and few guns.
d.
If both Hawks and Doves reduced their desired quantity of guns by the same amount,
the Hawks would get a bigger peace dividend because the production possibilities
frontier is much flatter at point H than at point D. As a result, the reduction of a given
number of guns, starting at point H, leads to a much larger increase in the quantity of
butter produced than when starting at point D.
See Figure 7. The shape and position of the frontier depend on how costly it is to maintain a
clean environment⎯the productivity of the environmental industry. Gains in environmental
productivity, such as the development of new way to produce electricity that emits fewer
pollutants, lead to shifts of the production-possibilities frontier, like the shift from PPF1 to PPF2
shown in the figure.
Figure 7
4.
a.
A: 40 lawns mowed; 0 washed cars
Chapter 2/Thinking Like an Economist ) 35
B: 0 lawns mowed, 40 washed cars
C: 20 lawns mowed; 20 washed cars
D: 25 lawns mowed; 25 washed cars
Quantity of
Cars
Washed
40
25
20
B
D
C
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A
20 25
40
Quantity of
Lawns Mowed
Figure 8
5
.
6.
b.
The production possibilities frontier is shown in Figure 8. Points A, B, and D are on the
frontier, while point C is inside the frontier.
c.
Larry is equally productive at both tasks. Moe is more productive at washing cars, while
Curly is more productive at mowing lawns.
d.
Allocation C is inefficient. More washed cars and mowed lawns can be produced by
simply reallocating the time of the three individuals.
a.
A family's decision about how much income to save is related to microeconomics.
b.
The effect of government regulations on auto emissions is related to microeconomics.
c.
The impact of higher saving on economic growth is related to macroeconomics.
d.
A firm's decision about how many workers to hire is related to microeconomics.
e.
The relationship between the inflation rate and changes in the quantity of money is
related to macroeconomics.
a.
The statement that society faces a short-run tradeoff between inflation and
unemployment is a positive statement. It deals with how the economy is, not how it
should be. Since economists have examined data and found that there is a short-run
36 ) Chapter 2/Thinking Like an Economist
negative relationship between inflation and unemployment, the statement is a fact, thus
it is a positive statement.
7.
b.
The statement that a reduction in the rate of growth of money will reduce the rate of
inflation is a positive statement. Economists have found that money growth and inflation
are very closely related. The statement thus tells how the world is, and so it is a positive
statement.
c.
The statement that the Federal Reserve should reduce the rate of growth of money is a
normative statement. It states an opinion about something that should be done, not
how the world is.
d.
The statement that society ought to require welfare recipients to look for jobs is a
normative statement. It does not state a fact about how the world is. Instead, it is a
statement of how the world should be and is thus a normative statement.
e.
The statement that lower tax rates encourage more work and more saving is a positive
statement. Economists have studied the relationship between tax rates and work, as
well as the relationship between tax rates and saving. They have found a negative
relationship in both cases. So the statement reflects how the world is, and is thus a
positive statement.
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Two of the statements in Table 2 are clearly normative. They are: "5. If the federal budget is
to be balanced, it should be done over the business cycle rather than yearly" and "9. The
government should restructure the welfare system along the lines of a 'negative income tax.'"
Both are suggestions of changes that should be made, rather than statements of fact, so they
are clearly normative statements.
The other statements in the table are positive. All the statements concern how the world is, not
how the world should be. They can each be evaluated using data.
8.
As the president, you would be interested in both the positive and normative views of
economists, but you would probably be most interested in their positive views. Economists are
on your staff to provide their expertise about how the economy works. They know many facts
about the economy and the interaction of different sectors. So you would be most likely to call
on them about questions of fact⎯positive analysis. Since you are the president, you are the one
who has to make the normative statements as to what should be done, with an eye to the
political consequences. The normative statements made by economists represent their own
views, not necessarily your views or the electorate’s views.
9.
There are many possible answers.
10.
There are many possible answers.
3
INTERDEPENDENCE AND THE
GAINS FROM TRADE
WHAT’S NEW IN THE FOURTH EDITION:
The section on “Comparative Advantage and Trade” has been augmented for improved clarity. There is a
new In the News box on “Evolution and Economics.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
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¾
how everyone can benefit when people trade with one another.
¾
the meaning of absolute advantage and comparative advantage.
¾
how comparative advantage explains the gains from trade.
¾
how to apply the theory of comparative advantage to everyday life and national policy.
CONTEXT AND PURPOSE:
Chapter 3 is the third chapter in the three-chapter section that serves as the introduction of the text.
Chapter 1 introduced ten fundamental principles of economics. Chapter 2 developed how economists
approach problems. This chapter shows how people and countries gain from trade (which is one of the
ten principles discussed in Chapter 1).
The purpose of Chapter 3 is to demonstrate how everyone can gain from trade. Trade allows
people to specialize in the production of goods for which they have a comparative advantage and then
trade for goods that other people produce. Because of specialization, total output rises, and through
trade we are all able to share in the bounty. This is as true for countries as it is for individuals. Because
everyone can gain from trade, restrictions on trade tend to reduce welfare.
KEY POINTS:
1. Each person consumes goods and services produced by many other people both in our country and
around the world. Interdependence and trade are desirable because they allow everyone to enjoy a
greater quantity and variety of goods and services.
37
38 ) Chapter 3/Interdependence and the Gains from Trade
2. There are two ways to compare the ability of two people in producing a good. The person who can
produce the good with a smaller quantity of inputs is said to have an absolute advantage in
producing the good. The person who has the smaller opportunity cost of producing the good is said
to have a comparative advantage. The gains from trade are based on comparative advantage, not
absolute advantage.
3. Trade makes everyone better off because it allows people to specialize in those activities in which
they have a comparative advantage.
4. The principle of comparative advantage applies to countries as well as people. Economists use the
principle of comparative advantage to advocate free trade among countries.
CHAPTER OUTLINE:
Begin by explaining that there are two basic ways that individuals can satisfy their
wants. The first is to be economically self-sufficient. The second is to specialize in the
production of one thing and then trade with others. With rare exceptions, individuals
and nations tend to rely on specialization and trade. One way to demonstrate this is
to survey the students on their future plans (doctors, lawyers, teachers, etc.). Point
out that they plan to specialize and trade. Ask them why this is optimal.
I.
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A Parable for the Modern Economy
A.
B.
Example: two goods—meat and potatoes; and two people—a cattle rancher and a potato
farmer (each of whom likes to consume both potatoes and meat).
1.
The gains from trade are obvious if the farmer can only grow potatoes and the
rancher can only raise cattle.
2.
The gains from trade are also obvious if, instead, the farmer can raise cattle as
well as grow potatoes, but he is not as good at it and the rancher can grow
potatoes in addition to raising cattle, but her land is not well suited for it.
3.
The gains from trade are not as clear if either the farmer or the rancher is better
at producing both potatoes and meat.
Production Possibilities
Make sure that you write out all of the algebra involved in this example. If you leave
out steps, students will not understand how these calculations are made.
1.
The farmer and rancher both work eight hours per day and can use this time to
grow potatoes, raise cattle, or both.
Chapter 3/Interdependence and the Gains from Trade ) 39
2.
Table 1 shows the amount of time each takes to produce one ounce of either
good:
Table 1
Minutes Needed to
Make One Ounce of:
Amount Produced in Eight
Hours
Meat
Potatoes
Meat
Potatoes
Farmer
60 min./oz.
15 min./oz.
8/1=8 oz.
8/0.25=22 oz.
Rancher
20 min./oz.
10 min./oz.
8/0.33=24 oz.
8/0.16=48 oz.
ALTERNATIVE CLASSROOM EXAMPLE:
Martha and Stewart each spend eight hours a day wallpapering and painting:
Hours Needed to Do One Room
Paint
Wallpaper
2 hours/room
8 hours/room
4 hours/room
10 hours/room
Rooms Finished in 40 Hours
Paint
Wallpaper
8/2=4 rooms
8/8=1 room
8/4=2 rooms
8/10=0.8 room
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Martha
Stewart
3.
The production possibilities frontiers can also be drawn.
a.
These production possibilities frontiers are drawn linearly instead of
being bowed out. This assumes that the farmer's and the rancher's
technology for producing meat and potatoes allows them to switch
between producing one good and the other at a constant rate.
b.
As we saw in Chapter 2, these production possibilities frontiers represent
the principles of trade-offs and opportunity costs.
It is important to take the time to explain how to calculate the x- and y-intercepts.
Point out that the farmer could produce 8 ounces of meat if all time is spent on meat
or 32 ounces of potatoes if all time is spent on potatoes.
40 ) Chapter 3/Interdependence and the Gains from Trade
4.
We will assume that the farmer and rancher divide their time equally between
raising cattle and growing potatoes.
Figure 1
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a.
The farmer produces (and consumes) at point A—16 ounces of potatoes
and 4 ounces of meat.
b.
The rancher produces (and consumes) at point B—24 ounces of potatoes
and 12 ounces of meat.
You should emphasize that these production possibilities frontiers represent the
farmer’s and the rancher’s consumption possibilities because we are assuming that
there is no trade.
C.
Specialization and Trade
1.
Suppose the rancher suggests that the farmer specialize in the production of
potatoes and then trade with the rancher for meat.
a.
The rancher will spend six hours a day producing meat (18 ounces) and
two hours a week growing potatoes (12 ounces).
b.
The farmer will spend eight hours a day growing potatoes (32 ounces).
c.
The rancher will trade 5 ounces of meat for 15 ounces of potatoes.
Students will ask how this “price” is determined. Explain the range of prices that each
participant would be willing to accept.
Chapter 3/Interdependence and the Gains from Trade ) 41
Figure 2
Table 2
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2.
3.
End results:
a.
The rancher produces 18 ounces of meat and trades 5 ounces, leaving
him with 13 ounces of meat. He also grows 12 ounces of potatoes and
receives 15 ounces in the trade, leaving him with 27 ounces of potatoes.
b.
The farmer produces 32 ounces of potatoes and trades 15 ounces,
leaving him with 17 ounces. He also receives 5 ounces of meat in the
trade with the rancher.
In both cases, they are able to consume quantities of potatoes and meat after
the trade that they could not reach before the trade.
Prove to your students that it would take each of them more than eight hours to
produce these quantities on their own.
II.
Comparative Advantage: The Driving Force of Specialization
A.
Absolute Advantage
1.
Definition of absolute advantage: the ability to produce a good using
fewer inputs than another producer does.
2.
The rancher has an absolute advantage in the production of both potatoes and
meat.
42 ) Chapter 3/Interdependence and the Gains from Trade
B.
Opportunity Cost and Comparative Advantage
1.
Definition of opportunity cost: whatever must be given up to obtain
some item.
Table 3
a.
For the rancher, it takes ten minutes to produce one ounce of potatoes.
Those same ten minutes could be used to produce one-half ounce of
meat. Thus, the opportunity cost of producing an ounce of potatoes is
one-half ounce of meat.
b.
For the farmer, it takes 15 minutes to produce one ounce of potatoes.
Those same 15 minutes could be used to produce one-fourth ounce of
meat. Therefore, the opportunity cost of producing one ounce of
potatoes is one-fourth ounce of meat.
c.
The opportunity cost of producing one ounce of meat is the inverse of
the opportunity cost of producing one ounce of potatoes.
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Your students may have a hard time comprehending this. Make sure that you go
through these calculations several times and write out every step on the board.
2.
3.
C.
Definition of comparative advantage: the ability to produce a good at a
lower opportunity cost than another producer.
a.
The farmer has a lower opportunity cost of producing potatoes and
therefore has a comparative advantage in the production of potatoes.
b.
The rancher has a lower opportunity cost of producing meat and
therefore has a comparative advantage in the production of meat.
Because the opportunity cost of producing one good is the inverse of the
opportunity cost of producing the other, it is impossible for a person to have a
comparative advantage in the production of both goods.
Comparative Advantage and Trade
1.
When specialization in a good occurs (assuming there is a comparative
advantage), total output will grow.
2.
As long as the opportunity cost of producing the goods differs across the two
individuals, both can gain from specialization and trade.
a.
The farmer buys 5 ounces of meat with 15 ounces of potatoes. This
implies that the price of each ounce of meat is three ounces of potatoes,
which is lower than the farmer's opportunity cost of four ounces of
potatoes. Trade is beneficial to the farmer.
Chapter 3/Interdependence and the Gains from Trade ) 43
b.
The rancher buys 15 ounces of potatoes for 5 ounces of meat. The price
of each ounce of potatoes is one-third ounce of meat. This is lower than
the rancher's opportunity cost of one-half ounce of meat. Trade also
benefits the rancher.
Activity 1 – Creating Comparative Advantage Examples
Type :
In-Class Assignment
Topics:
Specialization, interdependence, self-interest, comparative advantage
Materials needed:
3-5 candy bars (or similar items to use as prizes)
Time:
15 minutes (first day), depends on number of groups (second day)
Class limitations:
works in any size class
Purpose
This assignment allows students to further explore comparative advantage.
Instructions
Divide the class into groups of three or four to write a comparative advantage problem of
their own. Tell them to make creative, humorous, yet plausible examples.
Give the students fifteen minutes to work on creating their examples at the end of class.
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Instruct them to bring a neatly written copy of their examples for the next class when each
group will present its example to the rest of the class. Students should include tables and
figures similar to those used in class.
Let the students vote on which group has the best example and award a small prize to the
group’s members.
Make the examples available to all of the students in the class to use as practice problems for
the exam.
III.
IV.
FYI: The Legacy of Adam Smith and David Ricardo
A.
In Adam Smith's 1776 book An Inquiry into the Nature and Causes of the Wealth of
Nations, he writes of the ability of producers to benefit through specialization and trade.
B.
In David Ricardo's 1817 book Principles of Political Economy and Taxation, Ricardo
develops the theory of comparative advantage and argues against restrictions on free
trade.
C.
The benefits of free trade are an issue that is generally agreed upon by most economists,
and the theories and arguments developed by these two individuals 200 years ago are
still used today.
Applications of Comparative Advantage
A.
Should Tiger Woods Mow His Own Lawn?
1.
Imagine that Woods can mow his lawn faster than anyone else can.
44 ) Chapter 3/Interdependence and the Gains from Trade
B.
2.
This implies that he has an absolute advantage.
3.
Suppose that it takes him two hours to mow his lawn. In that same two hours,
he could film a commercial for Nike for which he would earn $10,000. This
means that the opportunity cost of mowing his lawn is $10,000.
4.
It is likely that someone else would have a lower opportunity cost of mowing
Woods’ lawn; this individual would have a comparative advantage.
5.
Both he and the person hired will be better off as long as he pays the individual
more than the individual's opportunity cost and less than $10,000.
Should the United States Trade with Other Countries?
1.
Just as individuals can benefit from specialization and trade, so can the
populations of different countries.
2.
Definition of imports: goods produced abroad and sold domestically.
3.
Definition of exports: goods produced domestically and sold abroad.
4.
The principle of comparative advantage suggests that each good should be
produced by the country with a comparative advantage in producing that good
(smaller opportunity cost).
5.
Through specialization and trade, countries can have more of all goods to
consume.
6.
Trade issues among nations are more complex. Some individuals can be made
worse off even when the country as a whole is made better off.
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C.
In the News: Evolution and Economics
1.
The theory of comparative advantage may help to explain evolution.
2.
This is an article from The Economist that describes research by an economist at
the University of Wyoming who suggests that trade and specialization are the
primary reasons why Homo sapiens remain the only species of humanity.
To help convince students that importing goods is not harmful to a country, ask the
students to devise a way to produce coffee domestically. Point out that it is possible
to grow coffee beans in the United States in enclosed nurseries, but the opportunity
cost of the resources used would be significant.
Discuss how differences in resource endowments can be significant factors in
determining opportunity cost and comparative advantage. Such differences include
climate, soil composition, education and training of the labor force, capital stock, and
infrastructure.
Chapter 3/Interdependence and the Gains from Trade ) 45
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
Figure 1 shows Robinson Crusoe’s production possibilities frontier for gathering coconuts and
catching fish. If Crusoe lives by himself, this frontier limits his consumption of coconuts and fish,
but if he can trade with natives on the island, he will possibly be able to consume at a point
outside his production possibilities frontier.
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Figure 1
2.
3.
Crusoe’s opportunity cost of catching one fish is 10 coconuts, since he can gather 10 coconuts in
the same amount of time it takes to catch one fish. Friday’s opportunity cost of catching one fish
is 15 coconuts, since he can gather 30 coconuts in the same amount of time it takes to catch two
fish. Friday has an absolute advantage in catching fish, since he can catch two per hour, while
Crusoe can catch only one per hour. But Crusoe has a comparative advantage in catching fish,
since his opportunity cost of catching a fish is less than Friday’s.
If the world’s fastest typist happens to be trained in brain surgery, he should hire a secretary
because the secretary will give up less for each hour spent typing. Although the brain surgeon
has an absolute advantage in typing, the secretary has a comparative advantage in typing
because of the lower opportunity cost of typing.
Questions for Review
1.
Absolute advantage reflects a comparison of the productivity of one person, firm, or nation to
that of another, while comparative advantage is based on the relative opportunity costs of the
persons, firms, or nations. While a person, firm, or nation may have an absolute advantage in
producing every good, they cannot have a comparative advantage in every good.
2.
Many examples are possible. Suppose, for example, that Roger can prepare a meal of hot dogs
and macaroni in just ten minutes, while it takes Anita 20 minutes. Also suppose that Roger can
do all the laundry in three hours, while it takes Anita four hours. Roger has an absolute
advantage in both cooking and doing the laundry, but Anita has a comparative advantage in
46 ) Chapter 3/Interdependence and the Gains from Trade
doing the laundry. For Anita, the opportunity cost of doing the laundry is 12 meals; for Roger, it
is 18 meals.
3.
Comparative advantage is more important for trade than absolute advantage. In the example in
problem 2, Anita and Roger will complete their chores more quickly if Anita does at least some of
the laundry and Roger cooks the meals for both, because Anita has a comparative advantage in
doing the laundry, while Roger has a comparative advantage in cooking.
4.
A nation will export goods for which it has a comparative advantage because it has a smaller
opportunity cost of producing those goods. As a result, citizens of all nations are able to consume
quantities of goods that are outside their production possibilities frontiers.
5.
Economists oppose policies that restrict trade among nations because trade allows all countries to
achieve greater prosperity by allowing them to receive the gains from comparative advantage.
Restrictions on trade hurt all countries.
Problems and Applications
1.
a.
See Figure 2. If Maria spends all five hours studying economics, she can read 100 pages,
so that is the vertical intercept of the production possibilities frontier. If she spends all
five hours studying sociology, she can read 250 pages, so that is the horizontal intercept.
The opportunity costs are constant, so the production possibilities frontier is a straight
line.
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Figure 2
b.
It takes Maria two hours to read 100 pages of sociology. In that time, she could read 40
pages of economics. So the opportunity cost of 100 pages of sociology is 40 pages of
economics.
Chapter 3/Interdependence and the Gains from Trade ) 47
2.
a.
U.S.
Japan
b.
Workers needed to make:
One Car
One Ton of Grain
1/4
1/10
1/4
1/5
See Figure 3. With 100 million workers and four cars per worker, if either economy were
devoted completely to cars, it could make 400 million cars. Because a U.S. worker can
produce 10 tons of grain, if the United States produced only grain it would produce 1,000
million tons. Because a Japanese worker can produce 5 tons of grain, if Japan produced
only grain it would produce 500 million tons. These are the intercepts of the production
possibilities frontiers shown in the figure. Note that because the trade-off between cars
and grain is constant for both countries, the production possibilities frontiers are straight
lines.
PMG
Figure 3
c.
Because a U.S. worker produces either four cars or ten tons of grain, the opportunity
cost of one car is two and one-half tons of grain, which is ten divided by four. Because a
Japanese worker produces either four cars or five tons of grain, the opportunity cost of
one car is one and one-fourth tons of grain, which is five divided by four. Similarly, the
U.S. opportunity cost of one ton of grain is 2/5 car (4 divided by 10) and the Japanese
opportunity cost of one ton of grain is 4/5 car (4 divided by 5). This results in the
following table:
U.S.
Japan
Opportunity Cost of:
One Car (in terms of tons
One Ton of Grain (in
of grain given up)
terms of cars given up)
2 1/2
2/5
1 1/4
4/5
48 ) Chapter 3/Interdependence and the Gains from Trade
3.
4.
d.
Neither country has an absolute advantage in producing cars, because they are equally
productive (the same output per worker); the United States has an absolute advantage
in producing grain, because it is more productive (greater output per worker).
e.
Japan has a comparative advantage in producing cars, because it has a lower
opportunity cost in terms of grain given up. The United States has a comparative
advantage in producing grain, because it has a lower opportunity cost in terms of cars
given up.
f.
With half the workers in each country producing each of the goods, the United States
would produce 200 million cars (50 million workers times 4 cars each) and 500 million
tons of grain (50 million workers times 10 tons each). Japan would produce 200 million
cars (50 million workers times 4 cars each) and 250 million tons of grain (50 million
workers times 5 tons each).
g.
From any situation with no trade, in which each country is producing some cars and
some grain, suppose the United States changed one worker from producing cars to
producing grain. That worker would produce four fewer cars and ten additional tons of
grain. Then suppose the United States offers to trade seven tons of grain to Japan for
four cars. The United States will do this because it values four cars at ten tons of grain,
so it will be better off if the trade goes through. Suppose Japan changes one worker
from producing grain to producing cars. That worker would produce four more cars and
five fewer tons of grain. Japan will take the trade because it values four cars at five tons
of grain, so it will be better off. With the trade and the change of one worker in both the
United States and Japan, each country gets the same amount of cars as before and both
get additional tons of grain (three for the United States and two for Japan). Thus, by
trading and changing their production, both countries are better off.
PMG
a.
Pat's opportunity cost of making a pizza is one-half gallon of root beer, because she
could brew one-half gallon in the time (two hours) it takes her to make a pizza. Pat has
an absolute advantage in making pizza because she can make one in two hours, while it
takes Kris four hours. Kris' opportunity cost of making a pizza is two-thirds gallon of root
beer, because she could brew two-thirds of a gallon in the time (four hours) it takes her
to make a pizza. Because Pat's opportunity cost of making pizza is less than Kris', Pat has
a comparative advantage in making pizza.
b.
Because Pat has a comparative advantage in making pizza, she will make pizza and
exchange it for root beer that Kris makes.
c.
The highest price of pizza in terms of root beer that will make both roommates better off
is two-thirds of a gallon of root beer. If the price were higher than that, then Kris would
prefer making her own pizza (at an opportunity cost of two-thirds of a gallon of root
beer) rather than trading for pizza that Pat makes. The lowest price of pizza in terms of
root beer that will make both roommates better off is one-half gallon of root beer. If the
price were lower than that, then Pat would prefer making her own root beer (she can
make one-half gallon of root beer instead of making a pizza) rather than trading for root
beer that Kris makes.
a.
Because a Canadian worker can make either two cars a year or 30 bushels of wheat, the
opportunity cost of a car is 15 bushels of wheat. Similarly, the opportunity cost of a
bushel of wheat is 1/15 of a car. The opportunity costs are the reciprocals of each other.
Chapter 3/Interdependence and the Gains from Trade ) 49
b.
See Figure 4. If all ten million workers produce two cars each, they produce a total of 20
million cars, which is the vertical intercept of the production possibilities frontier. If all ten
million workers produce 30 bushels of wheat each, they produce a total of 300 million
bushels, which is the horizontal intercept of the production possibilities frontier. Because
the trade-off between cars and wheat is always the same, the production possibilities
frontier is a straight line.
If Canada chooses to consume ten million cars, it will need five million workers devoted
to car production. That leaves five million workers to produce wheat, who will produce a
total of 150 million bushels (five million workers times 30 bushels per worker). This is
shown as point A on Figure 4.
c.
If the United States buys 10 million cars from Canada and Canada continues to consume
10 million cars, then Canada will need to produce a total of 20 million cars. So Canada
will be producing at the vertical intercept of the production possibilities frontier.
However, if Canada gets 20 bushels of wheat per car, it will be able to consume 200
million bushels of wheat, along with the 10 million cars. This is shown as point B in the
figure. Canada should accept the deal because it gets the same number of cars and 50
million more bushes of wheat.
PMG
Figure 4
5.
a.
English workers have an absolute advantage over Scottish workers in producing scones,
because English workers produce more scones per hour (50 vs. 40). Scottish workers
have an absolute advantage over English workers in producing sweaters, because
Scottish workers produce more sweaters per hour (2 vs. 1). Comparative advantage runs
the same way. English workers, who have an opportunity cost of 1/50 sweater per scone
(1 sweater per hour divided by 50 scones per hour), have a comparative advantage in
scone production over Scottish workers, who have an opportunity cost of 1/20 sweater
per scone (2 sweaters per hour divided by 40 scones per hour). Scottish workers, who
have an opportunity cost of 20 scones per sweater (40 scones per hour divided by 2
sweaters per hour), have a comparative advantage in sweater production over English
50 ) Chapter 3/Interdependence and the Gains from Trade
workers, who have an opportunity cost of 50 scones per sweater (50 scones per hour
divided by 1 sweater per hour).
6.
b.
If England and Scotland decide to trade, Scotland will produce sweaters and trade them
for scones produced in England. A trade with a price between 20 and 50 scones per
sweater will benefit both countries, as they will be getting the traded good at a lower
price than their opportunity cost of producing the good in their own country.
c.
Even if a Scottish worker produced just one sweater per hour, the countries would still
gain from trade, because Scotland would still have a comparative advantage in producing
sweaters. Its opportunity cost for sweaters would be higher than before (40 scones per
sweater, instead of 20 scones per sweater before). But there are still gains from trade
because England has a higher opportunity cost (50 scones per sweater).
a.
With no trade, one pair of white socks trades for one pair of red socks in Boston,
because productivity is the same for the two types of socks. The price in Chicago is two
pairs of red socks per pair of white socks.
b.
Boston has an absolute advantage in the production of both types of socks, because a
worker in Boston produces more (three pairs of socks per hour) than a worker in Chicago
(two pairs of red socks per hour or one pair of white socks per hour).
PMG
Chicago has a comparative advantage in producing red socks, because the opportunity
cost of producing a pair of red socks in Chicago is one-half pair of white socks, while the
opportunity cost of producing a pair of red socks in Boston is one pair of white socks.
Boston has a comparative advantage in producing white socks, because the opportunity
cost of producing a pair of white socks in Boston is one pair of red socks, while the
opportunity cost of producing a pair of white socks in Chicago is two pairs of red socks.
c.
If they trade socks, Boston will produce white socks for export, because it has the
comparative advantage in white socks, while Chicago produces red socks for export,
which is Chicago's comparative advantage.
d.
Trade can occur at any price between one and two pairs of red socks per pair of white
socks. At a price lower than one pair of red socks per pair of white socks, Boston will
choose to produce its own red socks (at a cost of one pair of red socks per pair of white
socks) instead of buying them from Chicago. At a price higher than two pairs of red
socks per pair of white socks, Chicago will choose to produce its own white socks (at a
cost of two pairs of red socks per pair of white socks) instead of buying them from
Boston.
Chapter 3/Interdependence and the Gains from Trade ) 51
7.
a.
The production possibilities frontiers for the two countries are shown in Figure 5. If,
without trade, a U.S. worker spends half of his time producing each good, the United
States will have 50 shirts and 10 computers. If, without trade, a worker in China spends
half of his time producing each good, China will have 50 shirts and 5 computers.
Quantity of
Computers
U.S.
20
10
China
5
50
100
Quantity
of Shirts
Figure 5
PMG
b.
For the United States, the opportunity cost of one computer is five shirts, while the
opportunity cost of one shirt is 1/5 computer. For China, the opportunity cost of one
computer is ten shirts, while the opportunity cost of one shirt is 1/10 computer.
Therefore, the United States has a comparative advantage in the production of
computers and China has a comparative advantage in the production of shirts.
China would export shirts. The price of a shirt will fall between 1/5 and 1/10 of a
computer. An example would be a price of 1/8 computer. In other words, China could
export eight shirts and receive one computer in return. Both countries would benefit from
trade. China would specialize in shirts (producing 100) and export eight. This would leave
them with 92 shirts. In return, they would get one computer. The combination of 92
shirts and 1 computer was not available to China before trade. The United States could
specialize in computers (producing 20) and export one computer to China in exchange
for eight shirts. The United States would end up with 19 computers and 8 shirts, a
combination that was impossible without trade.
8.
c.
The price of a computer would fall between five and ten shirts. If the price was below
five, the United States would not be willing to export computers because the opportunity
cost of a shirt for the United States is 1/5 computer. If the price was greater than ten
shirts, China would not be willing to import computers because (for China) the
opportunity cost of a computer is ten shirts.
d.
Once the productivity is the same in the two countries, the benefits of trade disappear.
Trade is beneficial because it allows countries to exploit their comparative advantage. If
China and the United States have exactly the same opportunity cost of producing shirts
and computers, there will be no more gains from trade available.
a.
True; two countries can achieve gains from trade even if one of the countries has an
absolute advantage in the production of all goods. All that is necessary is that each
country have a comparative advantage in some good.
52 ) Chapter 3/Interdependence and the Gains from Trade
9.
b.
False; it is not true that some people have a comparative advantage in everything they
do. In fact, no one can have a comparative advantage in everything. Comparative
advantage reflects the opportunity cost of one good or activity in terms of another. If you
have a comparative advantage in one thing, you must have a comparative disadvantage
in the other thing.
c.
False; it is not true that if a trade is good for one person, it cannot be good for the other
one. Trades can and do benefit both sides⎯especially trades based on comparative
advantage. If both sides did not benefit, trades would never occur.
d.
False; trade that makes the country better off can harm certain individuals in the
country. For example, suppose a country has a comparative advantage in producing
wheat and a comparative disadvantage in producing cars. Exporting wheat and importing
cars will benefit the nation as a whole, as it will be able to consume more of all goods.
However, the introduction of trade will likely be harmful to domestic auto workers and
manufacturers.
This pattern of trade is consistent with the principle of comparative advantage. If the United
States exports corn and aircraft, it must have a comparative advantage in the production of these
goods. Because it imports oil and clothing, the United States must have a comparative
disadvantage in the production of these items.
PMG
4
THE MARKET FORCES OF
SUPPLY AND DEMAND
WHAT’S NEW IN THE FOURTH EDITION:
The discussion of markets and competition has been improved. There is a new In the News box on how
“Political Unrest Shifts the Supply Curve.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
PMG
¾
what a competitive market is.
¾
what determines the demand for a good in a competitive market.
¾
what determines the supply of a good in a competitive market.
¾
how supply and demand together set the price of a good and the quantity sold.
¾
the key role of prices in allocating scarce resources in market economies.
CONTEXT AND PURPOSE:
Chapter 4 is the first chapter in a three-chapter sequence that deals with supply and demand and how
markets work. Chapter 4 shows how supply and demand for a good determines both the quantity
produced and the price at which the good sells. Chapter 5 will add precision to the discussion of supply
and demand by addressing the concept of elasticity—the sensitivity of the quantity supplied and quantity
demanded to changes in economic variables. Chapter 6 will address the impact of government policies on
prices and quantities in markets.
The purpose of Chapter 4 is to establish the model of supply and demand. The model of supply and
demand is the foundation for the discussion for the remainder of this text. For this reason, time spent
studying the concepts in this chapter will return benefits to your students throughout their study of
economics. Many instructors would argue that this chapter is the most important chapter in the text.
53
54 ) Chapter 4/The Market Forces of Supply and Demand
KEY POINTS:
1. Economists use the model of supply and demand to analyze competitive markets. In a competitive
market, there are many buyers and sellers, each of whom has little or no influence on the market
price.
2. The demand curve shows how the quantity of a good demanded depends on the price. According to
the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand
curve slopes downward.
3. In addition to price, other determinants of how much consumers want to buy include income, the
prices of substitutes and complements, tastes, expectations, and the number of buyers. If one of
these factors changes, the demand curve shifts.
4. The supply curve shows how the quantity of a good supplied depends on the price. According to the
law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve
slopes upward.
5. In addition to price, other determinants of how much producers want to sell include input prices,
technology, expectations, and the number of sellers. If one of these factors changes, the supply
curve shifts.
PMG
6. The intersection of the supply and demand curves determines the market equilibrium. At the
equilibrium price, the quantity demanded equals the quantity supplied.
7. The behavior of buyers and sellers naturally drives markets toward their equilibrium. When the
market price is above the equilibrium price, there is a surplus of the good, which causes the market
price to fall. When the market price is below the equilibrium price, there is a shortage, which causes
the market price to rise.
8. To analyze how any event influences a market, we use the supply-and-demand diagram to examine
how the event affects equilibrium price and quantity. To do this we follow three steps. First, we
decide whether the event shifts the supply curve or the demand curve (or both). Second, we decide
which direction the curve shifts. Third, we compare the new equilibrium with the initial equilibrium.
9. In market economies, prices are the signals that guide economic decisions and thereby allocate
scarce resources. For every good in the economy, the price ensures that supply and demand are in
balance. The equilibrium price then determines how much of the good buyers choose to purchase
and how much sellers choose to produce.
CHAPTER OUTLINE:
I.
Markets and Competition
You may want to provide students with examples of markets other than the
traditional retail store or the stock market. These include the classified advertising
section of a newspaper, the college “career services” department through which they
can look for employment upon graduation, or the market for illegal drugs on a
college campus. Be sure to list the good or service being sold, the buyers, and the
sellers in each example.
Chapter 4/The Market Forces of Supply and Demand ) 55
A.
B.
What Is a Market?
1.
Definition of market: a group of buyers and sellers of a particular good or
service.
2.
Markets can take many forms and may be organized (agricultural commodities)
or less organized (ice cream).
What Is Competition?
1.
Definition of competitive market: a market in which there are so many
buyers and so many sellers that each has a negligible impact on the
market price.
2.
Each buyer knows that there are several sellers from which to choose. Sellers
know that each buyer purchases only a small amount of the total amount sold.
Students may find the name for this type of market misleading. You will have to
point out that firms in a competitive market do not face head-to-head rivalry as in
sports competitions.
PMG
C.
In this chapter, we will assume that markets are perfectly competitive.
1.
D.
Characteristics of a perfectly competitive market:
a.
The goods being offered for sale are exactly the same.
b.
The buyers and sellers are so numerous that no single buyer or seller
has any influence over the market price.
2.
Because buyers and sellers must accept the market price as given, they are often
called "price takers."
3.
Not all goods are sold in a perfectly competitive market.
a.
A market with only one seller is called a monopoly market.
b.
Some markets fall between perfect competition and monopoly.
We will start by studying perfect competition.
1.
Perfectly competitive markets are the easiest to analyze because buyers and
sellers take the price as a given.
2.
Because some degree of competition is present in most markets, many of the
lessons that we learn by studying supply and demand under perfect competition
apply in more complicated markets.
56 ) Chapter 4/The Market Forces of Supply and Demand
II.
Demand
A.
The Demand Curve: The Relationship between Price and Quantity Demanded
1.
Definition of quantity demanded: the amount of a good that buyers are
willing and able to purchase.
2.
One important determinant of quantity demanded is the price of the product.
a.
Quantity demanded is negatively related to price. This implies that the
demand curve is downward sloping.
b.
Definition of law of demand: the claim that, other things being
equal, the quantity demanded of a good falls when the price of
the good rises.
Make sure that you explain that, when we discuss the relationship between quantity
demanded and price, we hold all other variables constant. You will need to
emphasize this more than once to ensure that students understand why a change in
price leads to a movement along the demand curve.
PMG
3.
Definition of demand schedule: a table that shows the relationship
between the price of a good and the quantity demanded.
Price of Ice Cream Cone
Quantity of Cones Demanded
$0.00
12
$0.50
10
$1.00
8
$1.50
6
$2.00
4
$2.50
2
$3.00
0
When you draw the demand curve for the first time, take the time to plot each of the
points from the demand schedule. This way, students who have difficulty with graphs
can see the relationship between the demand schedule and the demand curve. This
is a good time to see if students understand the (x, y) coordinate system.
4.
Definition of demand curve: a graph of the relationship between the
price of a good and the quantity demanded.
a.
Price is generally drawn on the vertical axis.
b.
Quantity demanded is represented on the horizontal axis.
Chapter 4/The Market Forces of Supply and Demand ) 57
ALTERNATIVE CLASSROOM EXAMPLE:
Here is a demand schedule for #2 lead pencils:
Price ($)
.05
.10
.15
.20
.25
Quantity Demanded
1000
800
600
400
200
Figure 1
PMG
B.
Market Demand versus Individual Demand
1.
The market demand is the sum of all of the individual demands for a particular
good or service.
2.
The demand curves are summed horizontally—meaning that the quantities
demanded are added up for each level of price.
3.
The market demand curve shows how the total quantity demanded of a good
varies with the price of the good, holding constant all other factors that affect
how much consumers want to buy.
Figure 2
C.
Shifts in the Demand Curve
Students have a difficult time understanding the difference between a change in
price (which causes a movement along the demand curve) and a change in another
determinant (which shifts the demand curve). You will have to emphasize what is
meant by “change in quantity demanded” and “change in demand” several times
using different examples. The Case Study on smoking will help to explain this
difference as well.
58 ) Chapter 4/The Market Forces of Supply and Demand
Figure 3
1.
The demand curve shows how much consumers want to buy at any price,
holding constant the many other factors that influence buying decisions.
2.
If any of these other factors change, the demand curve will shift.
3.
a.
An increase in demand is represented by a shift of the demand curve to
the right.
b.
A decrease in demand is represented by a shift of the demand curve to
the left.
Income
a.
The relationship between income and quantity demanded depends on
what type of good the product is.
b.
Definition of normal good: a good for which, other things being
equal, an increase in income leads to an increase in demand.
PMG
c.
Definition of inferior good: a good for which, other things being
equal, an increase in income leads to a decrease in demand.
Be careful! Students often confuse inferior goods with what economists call “bads.”
One way to differentiate them is to ask students whether they would ever be willing
to pay for such things as pollution or garbage.
4.
a.
Definition of substitutes: two goods for which an increase in the
price of one good leads to an increase in the demand for the
other.
b.
Definition of complements: two goods for which an increase in
the price of one good leads to a decrease in the demand for the
other.
5.
Tastes
6.
Expectations
7.
Table 1
Prices of Related Goods
a.
Future Income
b.
Future Prices
Number of Buyers
Chapter 4/The Market Forces of Supply and Demand ) 59
It would be a good idea to work through an example changing each of these
variables individually. Students will benefit from the discussion and the practice
drawing graphs.
D.
Case Study: Two Ways to Reduce the Quantity of Smoking Demanded
Figure 4
III.
1.
Public service announcements, mandatory health warnings on cigarette
packages, and the prohibition of cigarette advertising on television are policies
designed to reduce the demand for cigarettes (and shift the demand curve to the
left).
2.
Raising the price of cigarettes (through tobacco taxes) lowers the quantity of
cigarettes demanded.
a.
The demand curve does not shift in this case, however.
b.
An increase in the price of cigarettes can be shown by a movement
along the original demand curve.
PMG
3.
Studies have shown that a 10% increase in the price of cigarettes causes a 4%
reduction in the quantity of cigarettes demanded. For teens, a 10% increase in
price leads to a 12% drop in quantity demanded.
4.
Studies have also shown that a decrease in the price of cigarettes is associated
with greater use of marijuana. Thus, it appears that tobacco and marijuana are
complements.
Supply
If you have taken enough time teaching demand, students will catch on to supply
more quickly. However, remember that as consumers, students can understand
demand decisions more easily than supply decisions. You may want to point out to
them that they are suppliers (of their time and effort) in the labor market.
A.
The Supply Curve: The Relationship between Price and Quantity Supplied
1.
Definition of quantity supplied: the amount of a good that sellers are
willing and able to sell.
a.
Quantity supplied is positively related to price. This implies that the
supply curve will be upward sloping.
b.
Definition of law of supply: the claim that, other things being
equal, the quantity supplied of a good rises when the price of
the good rises.
60 ) Chapter 4/The Market Forces of Supply and Demand
Again you will want to point out that everything else is held constant when we
discuss the relationship between price and quantity supplied. Students should
understand that a change in price causes a movement along the supply curve.
2.
Definition of supply schedule: a table that shows the relationship
between the price of a good and the quantity supplied.
3.
Definition of supply curve: a graph of the relationship between the price
of a good and the quantity supplied.
Price of Ice Cream
Cone
Quantity of Cones
Supplied
$0.00
0
$0.50
0
$1.00
1
$1.50
2
$2.00
3
$2.50
4
$3.00
5
PMG
Figure 5
B.
Market Supply versus Individual Supply
Figure 6
1.
The market supply curve can be found by summing individual supply curves.
Chapter 4/The Market Forces of Supply and Demand ) 61
C.
2.
Individual supply curves are summed horizontally at every price.
3.
The market supply curve shows how the total quantity supplied varies as the
price of the good varies.
Shifts in the Supply Curve
Table 2
Figure 7
1.
The supply curve shows how much producers offer for sale at any given price,
holding constant all other factors that may influence producers’ decisions about
how much to sell.
2.
When any of these other factors change, the supply curve will shift.
a.
An increase in supply is represented by a shift of the supply curve to the
right.
PMG
b.
A decrease in supply is represented by a shift of the supply curve to the
left.
You will want to take time to emphasize the difference between a “change in supply”
and a “change in quantity supplied.”
IV.
3.
Input Prices
4.
Technology
5.
Expectations
6.
Number of Sellers
Supply and Demand Together
A.
Equilibrium
1.
The point where the supply and demand curves intersect is called the market’s
equilibrium.
Students will benefit from seeing equilibrium using both a graph and a supply-anddemand schedule. The schedule will also make it easier for students to understand
concepts such as shortages and surpluses.
2.
Definition of equilibrium: a situation in which the market price has
reached the level at which quantity supplied equals quantity
demanded.
62 ) Chapter 4/The Market Forces of Supply and Demand
3.
Definition of equilibrium price: the price that balances quantity supplied
and quantity demanded.
4.
The equilibrium price is often called the "market-clearing" price because both
buyers and sellers are satisfied at this price.
Figure 8
PMG
5.
Definition of equilibrium quantity: the quantity supplied and the quantity
demanded at the equilibrium price.
Activity 1—A Market Example
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Individual demand, market demand, equilibrium price, allocation
A bag of Pepperidge Farm cookies (15 cookies), 5 volunteers
35 minutes
Works in large lectures or small classes with over 15 students
Purpose
This is an example of a real-world market, where real goods are exchanged for real money. It
is a free market, so there will be no coercion, but participants should think carefully about
their answers because actual trades will take place.
Instructions
Ask five volunteers to participate in a market for Pepperidge Farm cookies. Read some of the
package copy describing these “distinctively delicious” cookies. Write each volunteer’s name
on the board.
Chapter 4/The Market Forces of Supply and Demand ) 63
Ask the volunteers how many cookies they would be willing to buy at various prices. Record
these prices and quantities. Give the volunteers the opportunity to revise their numbers, if the
figures do not accurately reflect their willingness to pay. Remind them this isn’t a hypothetical
exercise and they will have to pay real money.
At this point, there will be five individual demand curves, which can be graphed if desired.
Add the individual quantities at each price to find the market demand at that price. This
overall demand is used to find the market equilibrium. Sketch a graph of the market demand.
Supply, in this case, is fixed at the number of cookies in the bag. There are 15 cookies. No
more can be produced, and any leftovers will spoil. This gives a vertical supply curve in the
very short run at Q = 15. (Sketch the supply curve.)
Try various prices until the individual quantities sum to 15. This will give the equilibrium price
and quantity.
Distribute the cookies and collect money from each participant.
Points for Discussion
The demand curves display the typical inverse relation between price and quantity. (Remark
on any unusual patterns.) These tell us about each individual’s willingness to pay and reveal
information about the marginal benefits of additional cookies to each consumer.
PMG
Market demand is aggregated from individual demand curves.
Notice the consumers do not get an equal number of cookies. This is typical of markets,
because tastes and incomes vary across individuals.
6.
Figure 9
7.
If the actual market price is higher than the equilibrium price, there will be a
surplus of the good.
a.
Definition of surplus: a situation in which quantity supplied is
greater than quantity demanded.
b.
To eliminate the surplus, producers will lower the price until the market
reaches equilibrium.
If the actual price is lower than the equilibrium price, there will be a shortage of
the good.
a.
Definition of shortage: a situation in which quantity demanded is
greater than quantity supplied.
64 ) Chapter 4/The Market Forces of Supply and Demand
b.
Sellers will respond to the shortage by raising the price of the good until
the market reaches equilibrium.
PMG
8.
Definition of the law of supply and demand: the claim that the price of
any good adjusts to bring the supply and demand for that good into
balance.
Activity 2—Campus Parking
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
Demand, supply, disequilibrium, shortage, rationing
A shortage of student parking on campus
35 minutes
Works in large lectures or small classes, if there is a campus parking
problem.
Purpose
Nothing seems to generate more heated discussion than campus parking. If your school has a
parking shortage this assignment brings the ideas of price rationing and resource allocation to
an issue close to the students’ hearts.
Chapter 4/The Market Forces of Supply and Demand ) 65
A. K. Sen’s parable of the bamboo flute is a good introduction to this assignment: An artist
makes a beautiful instrument that becomes famous throughout the country. A number of
claimants arise, each of whom argues that they deserve the flute: the artist who created it,
the most talented musician, the poorest musician, the neediest citizen, the hardest working
musician, etc. Who deserves the flute? Students will have different opinions on who is most
deserving but many will accept a market solution—the person who is willing to pay the most
(who has the highest marginal benefit, given the existing distribution of wealth and income).
The allocation of campus parking spots makes a nice parallel.
Instruction
Ask the class to answer the following questions. Give them time to write an answer to a
question, then discuss their answers before moving to the next question.
Common Answers and Points for Discussion
1.
Write down three things that are true about the parking situation on campus.
2.
What two problems do you think are most important?
The parking problem has two components in the eyes of most students. Parking permits are
too expensive and there are too few spaces.
3.
What policies could the administration make to resolve these problems?
PMG
Students have many policies to alleviate the situation. The most common suggestion is to ban
parking for freshmen. Freshmen respond with lists of other groups who should be banned.
Another popular policy would be to open faculty lots to student parking. Parking fees should
be lowered or better yet eliminated. Parking violations should have lower fines. More lots
should be built. Shuttles, moving sidewalks, and monorails should be installed.
Students never suggest raising prices to reach a market solution.
4.
5.
Who needs parking the most?
Who would pay the most for parking?
Asking about need and willingness to pay moves the discussion away from group prohibitions;
freshmen may be just as needy and equally able to pay.
6.
Use a supply-and-demand graph to analyze this problem.
Many students initially have difficulty graphing this problem. They want to illustrate that
permit prices are too high, but then their graph will not show the shortage. Eventually they
can be convinced that parking, while expensive, is actually priced too low.
7.
How would your policy proposals affect the market for parking?
Analysis of the various proposals in a supply-and-demand framework shows some popular
policies, like free permits, would aggravate the parking shortage. Policies to restrict demand
can reduce the shortage, although there will be inefficiencies in the resulting allocation. Make
sure that students realize that building more parking lots is not a shift in the supply curve, but
a movement along the existing supply curve. The additional costs of new parking need to be
covered by some means: higher parking fees, tuition increases, or taxpayer subsidies.
66 ) Chapter 4/The Market Forces of Supply and Demand
B.
Three Steps to Analyzing Changes in Equilibrium
Table 3
1.
Decide whether the event shifts the supply or demand curve (or perhaps both).
2.
Determine the direction in which the curve shifts.
3.
Use the supply-and-demand diagram to see how the shift changes the
equilibrium price and quantity.
This three-step process is very important. Students often want to jump to the end
without thinking the change through. They should be provided with numerous
examples so that they can see the benefit of analyzing a change in equilibrium one
step at a time.
C.
Example: A Change in Demand — the effect of hot weather on the market for ice cream.
Figure 10
PMG
Go through changes in supply and demand carefully. Show students why the
equilibrium price must change after one of the curves shifts. For example, point out
that if demand rises, a shortage will occur at the original equilibrium price. This leads
to an increase in price, which causes quantity supplied to rise and quantity
demanded to fall until equilibrium is achieved. The end result is an increase in both
the equilibrium price and equilibrium quantity. Also point out that an increase in
demand leads to an increase in quantity supplied, not supply.
ALTERNATIVE CLASSROOM EXAMPLE:
Go through these examples of events that would shift either the demand or supply of #2 lead
pencils:
ƒ an increase in the income of consumers
ƒ an increase in the use of standardized exams (using opscan forms)
ƒ a decrease in the price of graphite (used in the production of pencils)
ƒ a decrease in the price of ink pens
ƒ the start of a school year
ƒ new technology that lowers the cost of producing pencils.
Type:
Topics:
Materials needed:
Time:
Class limitations:
Activity 3—Cold Soda
In-class demonstration
Demand, substitutes, and changing demand
None
15 minutes
Works in any class size
Chapter 4/The Market Forces of Supply and Demand ) 67
Purpose
This activity demonstrates the demand curve’s inverse relation between price and quantity.
Students answer a series of questions about their willingness to pay. Two demand curves are
found from the class responses, one with and one without a substitute good. These are
shared with the class.
Instructions
Ask the students to answer the following questions. These are hypothetical questions; no
exchange will actually take place.
1.
“Assume I have a cooler of ice-cold Pepsi-Cola. If I offered to sell you a Pepsi for $1.50
would you be willing to buy one? (Yes or no)”
2.
“If I offered to sell you a Pepsi for $1.00 would you be willing to buy one? (Yes or no)”
3.
“If I offered to sell you a Pepsi for $0.75 would you be willing to buy one? (Yes or no)”
4.
“If I offered to sell you a Pepsi for $0.50 would you be willing to buy one? (Yes or no)”
5.
“If I offered to sell you a Pepsi for $0.25 would you be willing to buy one? (Yes or no)”
6.
“Now assume I have 2 coolers, one full of ice-cold Pepsi-Cola and one full of ice-cold
Coca-Cola. I am going to repeat my offers to sell Pepsi, but now consider the availability
of Coke. Assume Coke is available as an alternative, and the price of Coke is always
$0.75. You can buy either Pepsi, or Coke, or nothing.”
7.
“If I offered to sell you a Pepsi for $1.50 would you be willing to buy one? (Answer ‘Yes’:
if you are willing to buy Pepsi. Answer ‘no’ if you would buy the Coke at $0.75 or if you
would buy nothing.)”
8.
“If I offered to sell you a Pepsi for $1.00 would you be willing to buy one? (Answer ‘Yes’:
if you are willing to buy Pepsi. Answer ‘no’ if you would buy the Coke at $0.75 or if you
would buy nothing.)”
9.
“If I offered to sell you a Pepsi for $0.75 would you be willing to buy one? (Answer ‘Yes’:
if you are willing to buy Pepsi. Answer ‘no’ if you would buy the Coke at $0.75 or if you
would buy nothing.)”
10. “If I offered to sell you a Pepsi for $0.50 would you be willing to buy one? (Answer ‘Yes’:
if you are willing to buy Pepsi. Answer ‘no’ if you would buy the Coke at $0.75 or if you
would buy nothing.)”
11. “If I offered to sell you a Pepsi for $0.25 would you be willing to buy one? (Answer ‘Yes’:
if you are willing to buy Pepsi. Answer ‘no’ if you would buy the Coke at $0.75 or if you
would buy nothing.)”
PMG
Collect the students’ responses and add the number of “yes” votes for each question.
Points for Discussion
Use the first 5 questions to draw a demand curve for Pepsi. More students will be willing to
buy Pepsi as its price decreases.
Use questions 6 through 10 to draw a second demand curve for Pepsi. This demand curve
shows the impact of lowering the price of a substitute good. (The price of Coke was
essentially infinite for the first questions, and it has dropped to $0.75 for the second set of
questions.) The demand for Pepsi will still be downward sloping, but fewer students will
choose Pepsi at any given price. This illustrates the decrease in demand when a substitute’s
price decreases.
68 ) Chapter 4/The Market Forces of Supply and Demand
D.
Shifts in Curves versus Movements along Curves
1.
A shift in the demand curve is called a "change in demand." A shift in the supply
curve is called a "change in supply."
Emphasize that students should not think about the curves shifting “up” and “down”
but rather think about the curves shifting “right” and “left” (or “out” and “in”). Point
out that an increase in demand (or supply) is an increase in the quantity demanded
(supplied) at every price. Thus, it is quantity that is getting larger. Review the same
principle with a decrease in demand (or supply).
2.
A movement along a fixed demand curve is called a "change in quantity
demanded." A movement along a fixed supply curve is called a "change in
quantity supplied."
It would helpful to students if you draw all four graphs (increase in demand,
decrease in demand, increase in supply, and decrease in supply) on the board at the
same time. Students will be able to see that the end result of each of these four
shifts is unique. Point out to students that they can use these graphs to explain
events going on in markets around them. For example, point out changes in gasoline
prices seen during the past several years. Then ask students what could have led to
these changes in price. Make sure that they realize that they would need to know the
effect on equilibrium quantity to determine the ultimate cause.
PMG
E.
Example: A Change in Supply — the effect of a hurricane that destroys part of the sugarcane crop and drives up the price of sugar.
Figure 11
In the News: Political Unrest Shifts the Supply Curve
F.
G.
1.
Newspaper articles about specific industries can give students practice
understanding the things that affect supply and demand.
2.
This is an article from the Boston Herald that describes the effect of political
unrest on the market for cocoa.
Example: A Change in Both Supply and Demand—the effect of both hot weather and a
hurricane that destroys part of the sugar cane crop.
Figure 12
Make sure that you explain to students that two possible outcomes might result,
depending on the relative sizes of the shifts in the demand and supply curves. Thus,
if they do not know the relative sizes of these shifts, the end effect on either
equilibrium price or equilibrium quantity will be ambiguous. Teach students to take
each change one at a time and to draw them on separate graphs.
Chapter 4/The Market Forces of Supply and Demand ) 69
Activity 4—Supply and Demand Article
Take-home assignment
Shifts in supply or demand, changing equilibrium
Works in any class
Type:
Topics:
Class limitations:
Purpose
This assignment is an excellent way to determine which students need extra help in
understanding supply and demand. Students who have difficulty with it often need remedial
help. Allowing students to correct errors and then resubmit the assignment can be worthwhile
because it is fundamental to their understanding of how markets work.
Instructions
Give the students the following assignment:
Find an article in a recent newspaper or magazine illustrating a change in price or quantity in
some market. Analyze the situation using economic reasoning.
1.
2.
3.
Has there been an increase or decrease in demand? Factors that could shift the
demand curve include changes in preferences, changes in income, changes in the
price of substitutes or complements, or changes in the number of consumers in the
market.
Has there been an increase or decrease in supply? Factors that could shift the supply
curve include changes in costs of materials, wages, or other inputs; changes in
technology; or changes in the number of firms in the market.
Draw a supply-and-demand graph to explain this change. Be sure to label your graph
and clearly indicate which curve shifts.
PMG
Ask students to turn in a copy of the article along with their explanation. Warn students to
avoid advertisements because they contain little information. They should be wary of
commodity and financial markets unless they have a good understanding of the particular
market. Markets for ordinary goods and services are most easily analyzed.
Points for Discussion
Most changes will only shift one curve—either supply or demand—not both. Remind students
that price changes will not cause either curve to shift. (But shifting either curve will change
price.)
Equilibrium points are not fixed. They change when supply or demand changes. Prices will not
necessarily return to previous levels nor will quantities.
Remind the students of the four graphs showing the shifts in supply and demand.
H.
Table 4
Summary
1.
When an event shifts the supply or demand curve, we can examine the effects
on the equilibrium price and quantity.
2.
Table 4 reports the end results of these shifts in supply and demand.
70 ) Chapter 4/The Market Forces of Supply and Demand
V.
Conclusion: How Prices Allocate Resources
A.
The model of supply and demand is a powerful tool for analyzing markets.
B.
Supply and demand together determine the prices of the economy’s goods and services.
1.
These prices serve as signals that guide the allocation of scarce resources in the
economy.
2.
Prices determine who produces each good and how much of each good is
produced.
Make a big deal about how well prices serve to allocate resources to their highest
valued uses. For example, suppose that consumers develop an increased taste for
corn and corn products. This leads to an increase in the demand for corn, pushing
the price up. This increased price provides incentives to producers to produce more
corn. Thus, price signals our wants and desires. This is one reason why markets are
generally the best way to organize economic activity.
PMG
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
2.
A market is a group of buyers (who determine demand) and a group of sellers (who determine
supply) of a particular good or service. A competitive market is one in which there are many
buyers and many sellers of an identical product so that each has a negligible impact on the
market price.
Here is an example of a demand schedule for pizza:
Price of Pizza Slice
$ 0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
The demand curve is graphed in Figure 1.
Number of Pizza Slices Demanded
10
9
8
7
6
5
4
3
2
1
0
Chapter 4/The Market Forces of Supply and Demand ) 71
Figure 1
Examples of things that would shift the demand curve include changes in income, prices of
related goods like soda or hot dogs, tastes, expectations about future income or prices, and the
number of buyers.
PMG
A change in the price of pizza would not shift this demand curve; it would only lead to a
movement from one point to another along the same demand curve.
3.
Here is an example of a supply schedule for pizza:
Price of Pizza Slice
$ 0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
The supply curve is graphed in Figure 2.
Number of Pizza Slices Supplied
0
100
200
300
400
500
600
700
800
900
1000
72 ) Chapter 4/The Market Forces of Supply and Demand
Figure 2
Examples of things that would shift the supply curve include changes in prices of inputs like
tomato sauce and cheese, changes in technology like more efficient pizza ovens or automatic
dough makers, changes in expectations about the future price of pizza, or a change in the
number of sellers.
PMG
A change in the price of pizza would not shift this supply curve; it would only lead to a movement
from one point to another along the same supply curve.
4.
If the price of tomatoes rises, the supply curve for pizza shifts to the left because there has been
an increase in the price of an input into pizza production, but there is no shift in demand. The
shift to the left of the supply curve causes the equilibrium price to rise and the equilibrium
quantity to decline, as Figure 3 shows.
If the price of hamburgers falls, the demand curve for pizza shifts to the left because the lower
price of hamburgers will lead consumers to buy more hamburgers and fewer pizzas, but there is
no shift in supply. The shift to the left of the demand curve causes the equilibrium price to fall
and the equilibrium quantity to decline, as Figure 4 shows.
Figure 3
Chapter 4/The Market Forces of Supply and Demand ) 73
Figure 4
PMG
Questions for Review
1.
2.
3.
A competitive market is a market in which there are many buyers and many sellers of an identical
product so that each has a negligible impact on the market price. Another type of market is a
monopoly, in which there is only one seller. There are also other markets that fall between
perfect competition and monopoly.
The quantity of a good that buyers demand is determined by the price of the good, income, the
prices of related goods, tastes, expectations, and the number of buyers.
The demand schedule is a table that shows the relationship between the price of a good and the
quantity demanded. The demand curve is the downward-sloping line relating price and quantity
demanded. The demand schedule and demand curve are related because the demand curve is
simply a graph showing the points in the demand schedule.
The demand curve slopes downward because of the law of demand—other things being equal,
when the price of a good rises, the quantity demanded of the good falls. People buy less of a
good when its price rises, both because they cannot afford to buy as much and because they
switch to purchasing other goods.
4.
A change in consumers' tastes leads to a shift of the demand curve. A change in price leads to a
movement along the demand curve.
5.
Because Popeye buys more spinach when his income falls, spinach is an inferior good for him.
Because he buys more spinach and the price of spinach is unchanged, his demand curve for
spinach shifts out as a result of the decrease in his income.
6.
The quantity of a good that sellers supply is determined by the price of the good, input prices,
technology, expectations, and the number of sellers.
74 ) Chapter 4/The Market Forces of Supply and Demand
7.
A supply schedule is a table showing the relationship between the price of a good and the
quantity a producer is willing and able to supply. The supply curve is the upward-sloping line
relating price and quantity supplied. The supply schedule and the supply curve are related
because the supply curve is simply a graph showing the points in the supply schedule.
The supply curve slopes upward because when the price is high, suppliers' profits increase, so
they supply more output to the market. The result is the law of supply—other things being equal,
when the price of a good rises, the quantity supplied of the good also rises.
8.
A change in producers' technology leads to a shift in the supply curve. A change in price leads to
a movement along the supply curve.
9.
The equilibrium of a market is the point at which the quantity demanded is equal to quantity
supplied. If the price is above the equilibrium price, sellers want to sell more than buyers want to
buy, so there is a surplus. Sellers try to increase their sales by cutting prices. That continues until
they reach the equilibrium price. If the price is below the equilibrium price, buyers want to buy
more than sellers want to sell, so there is a shortage. Sellers can raise their price without losing
customers. That continues until they reach the equilibrium price.
10.
When the price of beer rises, the demand for pizza declines, because beer and pizza are
complements and people want to buy less beer. When we say the demand for pizza declines, we
mean that the demand curve for pizza shifts to the left as in Figure 5. The supply curve for pizza
is not affected. With a shift to the left in the demand curve, the equilibrium price and quantity
both decline, as the figure shows. Thus, the quantity of pizza supplied and demanded both fall.
In sum, supply is unchanged, demand is decreased, quantity supplied declines, quantity
demanded declines, and the price falls.
PMG
Figure 5
11.
Prices play a vital role in market economies because they bring markets into equilibrium. If the
price is different from its equilibrium level, quantity supplied and quantity demanded are not
equal. The resulting surplus or shortage leads suppliers to adjust the price until equilibrium is
restored. Prices thus serve as signals that guide economic decisions and allocate scarce
resources.
Chapter 4/The Market Forces of Supply and Demand ) 75
Problems and Applications
1.
a.
Cold weather damages the orange crop, reducing the supply of oranges. This can be
seen in Figure 6 as a shift to the left in the supply curve for oranges. The new
equilibrium price is higher than the old equilibrium price.
PMG
Figure 6
b.
People often travel to the Caribbean from New England to escape cold weather, so the
demand for Caribbean hotel rooms is high in the winter. In the summer, fewer people
travel to the Caribbean, because northern climes are more pleasant. The result, as
shown in Figure 7, is a shift to the left in the demand curve. The equilibrium price of
Caribbean hotel rooms is thus lower in the summer than in the winter, as the figure
shows.
Figure 7
76 ) Chapter 4/The Market Forces of Supply and Demand
c.
When a war breaks out in the Middle East, many markets are affected. Because a large
proportion of oil production takes place there, the war disrupts oil supplies, shifting the
supply curve for gasoline to the left, as shown in Figure 8. The result is a rise in the
equilibrium price of gasoline. With a higher price for gasoline, the cost of operating a
gas-guzzling automobile like a Cadillac will increase. As a result, the demand for used
Cadillacs will decline, as people in the market for cars will not find Cadillacs as attractive.
In addition, some people who already own Cadillacs will try to sell them. The result is
that the demand curve for used Cadillacs shifts to the left, while the supply curve shifts
to the right, as shown in Figure 9. The result is a decline in the equilibrium price of used
Cadillacs.
PMG
Figure 8
2.
Figure 9
The statement that "an increase in the demand for notebooks raises the quantity of notebooks
demanded, but not the quantity supplied," in general, is false. As Figure 10 shows, the increase
in demand for notebooks results in an increased quantity supplied. The only way the statement
would be true is if the supply curve was a vertical line, as shown in Figure 11.
Figure 10
Chapter 4/The Market Forces of Supply and Demand ) 77
Figure 11
3.
a.
If people decide to have more children, they will want larger vehicles for hauling their
kids around, so the demand for minivans will increase. Supply will not be affected. The
result is a rise in both the price and the quantity sold, as Figure 12 shows.
PMG
Figure 12
b.
If a strike by steelworkers raises steel prices, the cost of producing a minivan rises and
the supply of minivans decreases. Demand will not be affected. The result is a rise in the
price of minivans and a decline in the quantity sold, as Figure 13 shows.
78 ) Chapter 4/The Market Forces of Supply and Demand
Figure 13
c.
The development of new automated machinery for the production of minivans is an
improvement in technology. This reduction in firms' costs will result in an increase in
supply. Demand is not affected. The result is a decline in the price of minivans and an
increase in the quantity sold, as Figure 14 shows.
PMG
Figure 14
d.
The rise in the price of sport utility vehicles affects minivan demand because sport utility
vehicles are substitutes for minivans. The result is an increase in demand for minivans.
Supply is not affected. The equilibrium price and quantity of minivans both rise, as Figure
12 shows.
e.
The reduction in peoples' wealth caused by a stock-market crash reduces their income,
leading to a reduction in the demand for minivans, because minivans are likely a normal
good. Supply is not affected. As a result, both the equilibrium price and the equilibrium
quantity decline, as Figure 15 shows.
Chapter 4/The Market Forces of Supply and Demand ) 79
Figure 15
4.
a.
DVDs and TV screens are likely to be complements because you cannot watch a DVD
without a television. DVDs and movie tickets are likely to be substitutes because a movie
can be watched at a theater or at home. TV screens and movie tickets are likely to be
substitutes for the same reason.
PMG
b.
The technological improvement would reduce the cost of producing a TV screen, shifting
the supply curve to the right. The demand curve would not be affected. The result is that
the equilibrium price will fall, while the equilibrium quantity will rise. This is shown in
Figure 16.
Price of
TV Screens
S1
S2
D
Quantity of
TV Screens
Figure 16
c.
The reduction in the price of TV screens would lead to an increase in the demand for
DVDs because TV screens and DVDs are complements. The effect of this increase in the
80 ) Chapter 4/The Market Forces of Supply and Demand
demand for DVDs is an increase in both the equilibrium price and quantity, as shown in
Figure 17.
Price of
DVDs
S
D2
D1
Quantity
of DVDs
PMG
Figure 17
d.
The reduction in the price of TV screens would cause a decline in the demand for movie
tickets because TV screens and movie tickets are substitute goods. The decline in the
demand for movie tickets would lead to a decline in the equilibrium price and quantity
sold. This is shown in Figure 18.
Price of
Movie
Tickets
S
D1
D2
Quantity of
Movie Tickets
Figure 18
Chapter 4/The Market Forces of Supply and Demand ) 81
5.
Technological advances that reduce the cost of producing computer chips represent a decline in
an input price for producing a computer. The result is a shift to the right in the supply of
computers, as shown in Figure 19. The equilibrium price falls and the equilibrium quantity rises,
as the figure shows.
PMG
Figure 19
Because computer software is a complement to computers, the lower equilibrium price of
computers increases the demand for software. As Figure 20 shows, the result is a rise in both the
equilibrium price and quantity of software.
Figure 20
82 ) Chapter 4/The Market Forces of Supply and Demand
Because typewriters are substitutes for computers, the lower equilibrium price of computers
reduces the demand for typewriters. As Figure 21 shows, the result is a decline in both the
equilibrium price and quantity of typewriters.
PMG
Figure 21
6.
A movement along a supply curve is caused by a change in the price of the good. Thus, the
statement that “As the price goes up, farmers have motivation to do anything they can to get
their product to market” refers to a movement along the supply curve. A shift in the supply curve
is caused by a change in a nonprice determinant of supply. Thus, the statement that “Political
unrest overseas threatens to disrupt the supply of America’s sweetest temptations” refers to a
shift in the supply curve.
Chapter 4/The Market Forces of Supply and Demand ) 83
7.
a.
When a hurricane in South Carolina damages the cotton crop, it raises input prices for
producing sweatshirts. As a result, the supply of sweatshirts shifts to the left, as shown
in Figure 22. The new equilibrium price is higher and the new equilibrium quantity of
sweatshirts is lower.
PMG
Figure 22
b.
A decline in the price of leather jackets leads more people to buy leather jackets,
reducing the demand for sweatshirts. The result, shown in Figure 23, is a decline in both
the equilibrium price and quantity of sweatshirts.
Figure 23
84 ) Chapter 4/The Market Forces of Supply and Demand
c.
The effects of colleges requiring students to engage in morning exercise in appropriate
attire raises the demand for sweatshirts, as shown in Figure 24. The result is an increase
in both the equilibrium price and quantity of sweatshirts.
PMG
Figure 24
d.
The invention of new knitting machines increases the supply of sweatshirts. As Figure 25
shows, the result is a reduction in the equilibrium price and an increase in the equilibrium
quantity of sweatshirts.
Figure 25
Chapter 4/The Market Forces of Supply and Demand ) 85
8.
A temporarily high birth rate in the year 2010 leads to opposite effects on the price of babysitting services in the years 2015 and 2025. In the year 2015, there are more five-year olds who
need sitters, so the demand for baby-sitting services rises, as shown in Figure 26. The result is a
higher price for baby-sitting services in 2015. However, in the year 2025, the increased number
of 15-year-olds shifts the supply of baby-sitting services to the right, as shown in Figure 27. The
result is a decline in the price of baby-sitting services.
PMG
Figure 26
9.
Figure 27
Ketchup is a complement for hot dogs. Therefore, when the price of hot dogs rises, the quantity
demanded of hot dogs falls and this lowers the demand for ketchup. The end result is that both
the equilibrium price and quantity of ketchup fall. Because the quantity of ketchup falls, the
demand for tomatoes by ketchup producers falls, so the equilibrium price and quantity of
tomatoes fall. When the price of tomatoes falls, producers of tomato juice face lower input
prices, so the supply curve for tomato juice shifts out, causing the price of tomato juice to fall
and the quantity of tomato juice to rise. The fall in the price of tomato juice causes people to
substitute tomato juice for orange juice, so the demand for orange juice declines, causing the
price and quantity of orange juice to fall. Now you can see clearly why a rise in the price of hot
dogs leads to a fall in the price of orange juice!
86 ) Chapter 4/The Market Forces of Supply and Demand
10.
Quantity supplied equals quantity demanded at a price of $6 and quantity of 81 pizzas (Figure
28). If the price were greater than $6, quantity supplied would exceed quantity demanded, so
suppliers would reduce the price to gain sales. If the price were less than $6, quantity demanded
would exceed quantity supplied, so suppliers could raise the price without losing sales. In both
cases, the price would continue to adjust until it reached $6, the only price at which there is
neither a surplus nor a shortage.
PMG
Figure 28
11.
a.
Because flour is an ingredient in bagels, a decline in the price of flour would shift the
supply curve for bagels to the right. The result, shown in Figure 29, would be a fall in the
price of bagels and a rise in the equilibrium quantity of bagels.
Figure 29
Chapter 4/The Market Forces of Supply and Demand ) 87
Because cream cheese is a complement to bagels, the fall in the equilibrium price of
bagels increases the demand for cream cheese, as shown in Figure 30. The result is a
rise in both the equilibrium price and quantity of cream cheese. So, a fall in the price of
flour indeed raises both the equilibrium price of cream cheese and the equilibrium
quantity of bagels.
PMG
Figure 30
What happens if the price of milk falls? Because milk is an ingredient in cream cheese,
the fall in the price of milk leads to an increase in the supply of cream cheese. This leads
to a decrease in the price of cream cheese (Figure 31), rather than a rise in the price of
cream cheese. So a fall in the price of milk could not have been responsible for the
pattern observed.
Figure 31
88 ) Chapter 4/The Market Forces of Supply and Demand
b.
In part (a), we found that a fall in the price of flour led to a rise in the price of cream
cheese and a rise in the equilibrium quantity of bagels. If the price of flour rose, the
opposite would be true; it would lead to a fall in the price of cream cheese and a fall in
the equilibrium quantity of bagels. Because the question says the equilibrium price of
cream cheese has risen, it could not have been caused by a rise in the price of flour.
What happens if the price of milk rises? From part (a), we found that a fall in the price of
milk caused a decline in the price of cream cheese, so a rise in the price of milk would
cause a rise in the price of cream cheese. Because bagels and cream cheese are
complements, the rise in the price of cream cheese would reduce the demand for bagels,
as Figure 32 shows. The result is a decline in the equilibrium quantity of bagels. So a rise
in the price of milk does cause both a rise in the price of cream cheese and a decline in
the equilibrium quantity of bagels.
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Figure 32
Chapter 4/The Market Forces of Supply and Demand ) 89
12.
a.
As Figure 33 shows, the supply curve is vertical. The constant quantity supplied makes
sense because the basketball arena has a fixed number of seats at any price.
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Figure 33
b.
Quantity supplied equals quantity demanded at a price of $8. The equilibrium quantity is
8,000 tickets.
c.
Price
$4
$8
$12
$16
$20
Quantity Demanded
14,000
11,000
8,000
5,000
2,000
Quantity Supplied
8,000
8,000
8,000
8,000
8,000
The new equilibrium price will be $12, which equates quantity demanded to quantity
supplied. The equilibrium quantity remains 8,000 tickets.
13.
Equilibrium occurs where quantity demanded is equal to quantity supplied. Thus:
Qd = Qs
1,600 – 300P = 1,400 + 700P
200 = 1,000P
P = $0.20
Qd = 1,600 – 300(0.20) = 1,600 – 60 = 1,540
Qs = 1,400 + 700(0.20) = 1,400 + 140 = 1,540.
The equilibrium price of a chocolate bar is $0.20 and the equilibrium quantity is 1,540 bars.
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5
ELASTICITY AND ITS
APPLICATION
WHAT’S NEW IN THE FOURTH EDITION:
There is a new In the News box that discusses the short-run and long-run price elasticity of demand for
gasoline.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
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¾
the meaning of the elasticity of demand.
¾
what determines the elasticity of demand.
¾
the meaning of the elasticity of supply.
¾
what determines the elasticity of supply.
¾
the concept of elasticity in three very different markets (the market for wheat, the market for oil, and
the market for illegal drugs).
CONTEXT AND PURPOSE:
Chapter 5 is the second chapter of a three-chapter sequence that deals with supply and demand and how
markets work. Chapter 4 introduced supply and demand. Chapter 5 shows how much buyers and sellers
respond to changes in market conditions. Chapter 6 will address the impact of government polices on
competitive markets.
The purpose of Chapter 5 is to add precision to the supply-and-demand model. We introduce the
concept of elasticity, which measures the responsiveness of buyers and sellers to changes in economic
variables such as prices and income. The concept of elasticity allows us to make quantitative observations
about the impact of changes in supply and demand on equilibrium prices and quantities.
91
92 ) Chapter 5/Elasticity and Its Application
KEY POINTS:
1. The price elasticity of demand measures how much the quantity demanded responds to changes in
the price. Demand tends to be more elastic if close substitutes are available, if the good is a luxury
rather than a necessity, if the market is narrowly defined, or if buyers have substantial time to react
to a price change.
2. The price elasticity of demand is calculated as the percentage change in quantity demanded divided
by the percentage change in price. If the elasticity is less than one, so that quantity demanded
moves proportionately less than the price, demand is said to be inelastic. If the elasticity is greater
than one, so that quantity demanded moves proportionately more than the price, demand is said to
be elastic.
3. Total revenue, the total amount paid for a good, equals the price of the good times the quantity sold.
For inelastic demand curves, total revenue rises as price rises. For elastic demand curves, total
revenue falls as price rises.
4. The income elasticity of demand measures how much the quantity demanded responds to changes in
consumers’ income. The cross-price elasticity of demand measures how much the quantity demanded
of one good responds to the price of another good.
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5. The price elasticity of supply measures how much the quantity supplied responds to changes in the
price. This elasticity often depends on the time horizon under consideration. In most markets, supply
is more elastic in the long run than in the short run.
6. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by
the percentage change in price. If the elasticity is less than one, so that quantity supplied moves
proportionately less than the price, supply is said to be inelastic. If the elasticity is greater than one,
so that quantity supplied moves proportionately more than the price, supply is said to be elastic.
7. The tools of supply and demand can be applied in many different kinds of markets. This chapter uses
them to analyze the market for wheat, the market for oil, and the market for illegal drugs.
CHAPTER OUTLINE:
I.
The Elasticity of Demand
A.
Definition of elasticity: a measure of the responsiveness of quantity demanded
or quantity supplied to one of its determinants.
B.
The Price Elasticity of Demand and Its Determinants
1.
Definition of price elasticity of demand: a measure of how much the
quantity demanded of a good responds to a change in the price of that
good, computed as the percentage change in quantity demanded
divided by the percentage change in price.
Chapter 5/Elasticity and Its Application ) 93
2.
C.
Determinants of Price Elasticity of Demand
a.
Availability of Close Substitutes: the more substitutes a good has, the
more elastic its demand.
b.
Necessities versus Luxuries: necessities are more price inelastic.
c.
Definition of the market: narrowly defined markets (ice cream) have
more elastic demand than broadly defined markets (food).
d.
Time Horizon: goods tend to have more elastic demand over longer time
horizons.
Computing the Price Elasticity of Demand
1.
Formula
Price elasticity of demand =
% change in quantity demanded
% change in price
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Work through a few elasticity calculations, starting with the example in the book. For
principles of economics courses where there is no mathematical prerequisite, this
may be difficult for some students. Working through a few simple examples will help
to alleviate some of the students’ anxiety. Show every step of the algebra involved.
2.
Example: the price of ice cream rises by 10% and quantity demanded falls by
20%.
Price elasticity of demand = (20%)/(10%) = 2
3.
Because there is an inverse relationship between price and quantity demanded
(the price of ice cream rose by 10% and the quantity demanded fell by 20%),
the price elasticity of demand is sometimes reported as a negative number. We
will ignore the minus sign and concentrate on the absolute value of the elasticity.
Students hate this! Explain that it really makes things easier and makes more sense
because larger elasticities (in absolute value) imply greater sensitivity and
responsiveness.
D.
The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities
1.
Because we use percentage changes in calculating the price elasticity of demand,
the elasticity calculated by going from one point to another on a demand curve will
be different from an elasticity calculated by going from the second point to the
first. This difference arises because the percentage changes are calculated using a
different base.
a.
A way around this problem is to use the midpoint method.
94 ) Chapter 5/Elasticity and Its Application
b.
Using the midpoint method involves calculating the percentage change in
either price or quantity demanded by dividing the change in the variable
by the midpoint between the initial and final levels rather than by the
initial level itself.
c.
Example: the price rises from $4 to $6 and quantity demanded falls from
120 to 80.
% change in price = (6 - 4)/5 × 100% = 40%
% change in quantity demanded = (120-80)/100 = 40%
price elasticity of demand = 40/40 = 1
Price elasticity of demand =
E.
(Q 2 - Q1) /[(Q1 + Q 2) / 2]
(P 2 - P 1) /[(P 1 + P 2) / 2]
The Variety of Demand Curves
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Figure 1
To clearly show the differences between relatively elastic and relatively inelastic
demand curves, draw a graph on the board showing a relatively flat demand curve
and one showing a relatively steep demand curve. Show that any given change in
price will result in a larger change in quantity demanded if the demand curve is
relatively flat. Use the same method when discussing the shape of the supply curve
later in the chapter.
1.
Classification of Elasticity
a.
When the price elasticity of demand is greater than one, demand is
elastic.
Chapter 5/Elasticity and Its Application ) 95
b.
When the price elasticity of demand is less than one, the demand is
inelastic.
c.
When the price elasticity of demand is equal to one, the demand has
unit elasticity.
Activity 1—How the Ball Bounces
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Elastic, inelastic
One rubber ball and one “dead” ball. The “dead” ball is made of
shock-absorbing material and doesn’t bounce. Museum stores and
magic shops carry them.
1 minute
Works in any size class
Purpose
This quick, but memorable, demonstration can be used to introduce the concepts of elastic
and inelastic.
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Instructions
Bring two students to the front of the class. Give each of them a ball and ask them to bounce
it off the floor and catch it. The student with the rubber ball can do this easily. The student
with the “dead” ball will not be able to bounce it high enough to catch, no matter how hard
he or she throws it.
Explain that one ball is elastic; it is responsive to change. The other ball is inelastic; it
responds very little to change. These physical properties of elastic and inelastic are analogous
to the economic concepts of elastic and inelastic.
2.
In general, the flatter the demand curve that passes through a given point, the
more elastic the demand.
96 ) Chapter 5/Elasticity and Its Application
Make sure that you provide several examples of goods with these types of demand
curves. You may want to point out that students will see the perfectly elastic demand
curve again when competitive firms are discussed.
3.
Extreme Cases
a.
When the price elasticity of demand is equal to zero, the demand is
perfectly inelastic and is a vertical line.
b.
When the price elasticity of demand is infinite, the demand is perfectly
elastic and is a horizontal line.
Activity 2—Ranking Elasticities
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
The determinants of price elasticity of demand
None
20 minutes
Works in any size class
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Purpose
The intent of this exercise is to get students to think about varying degrees of elasticity and
the factors that determine demand elasticity.
Instructions
Give the students the following list of goods. Ask them to rank them from most to least
elastic.
1.
beef
2.
salt
3.
European vacation
4.
steak
5.
Honda Accord
6.
Dijon mustard
If they have difficulty, these hints can be helpful:
1.
How much would a 10% price increase for the good affect a consumer’s total budget?
2.
What substitutes are available for the good?
3.
Do consumers think of this good as a necessity or a luxury?
Common Answers and Points for Discussion
A typical ranking:
1.
European vacation (luxury, many other vacation destinations, expensive)
2.
Honda Accord (expensive, many substitutes including used cars)
3.
steak (perceived luxury, moderate expense, other cuts of beef are close substitutes)
4.
Dijon mustard (perceived luxury, inexpensive, other types of mustard may be close
substitutes.)
5.
beef (moderate expense, pork & chicken are substitutes)
6.
salt (inexpensive, necessity, no close substitutes)
Chapter 5/Elasticity and Its Application ) 97
F.
Total Revenue and the Price Elasticity of Demand
Figure 2
1.
Definition of total revenue: the amount paid by buyers and received by
sellers of a good, computed as the price of the good times the quantity
sold.
Another term for price times quantity is “total expenditure.” This term is sometimes
used in questions found in the study guide and test bank. It is also important to
point this out when discussing the market for illegal drugs at the end of the chapter.
Students find the relationship between changes in total revenue and elasticity difficult
to understand. It may take several thorough discussions of this material before
students will be able to master it.
2.
If demand is inelastic, the percentage change in price will be greater than the
percentage change in quantity demanded.
Figure 3
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3.
4.
a.
If price rises, quantity demanded falls, and total revenue will rise
(because the increase in price will be larger than the decrease in
quantity demanded).
b.
If price falls, quantity demanded rises, and total revenue will fall
(because the fall in price will be larger than the increase in quantity
demanded).
If demand is elastic, the percentage change in quantity demanded will be greater
than the percentage change in price.
a.
If price rises, quantity demanded falls, and total revenue will fall
(because the increase in price will be smaller than the decrease in
quantity demanded).
b.
If price falls, quantity demanded rises, and total revenue will rise
(because the fall in price will be smaller than the increase in quantity
demanded).
If demand is unit elastic, the percentage change in price will be equal to the
percentage change in quantity demanded.
a.
If price rises, quantity demanded falls, and total revenue will remain the
same (because the increase in price will be equal to the decrease in
quantity demanded).
b.
If price falls, quantity demanded rises, and total revenue will remain the
same (because the fall in price will be equal to the increase in quantity
demanded).
98 ) Chapter 5/Elasticity and Its Application
Point out the usefulness of elasticity from a business owner’s point of view. Students
should be able to see why a firm manager would want to know the elasticity of
demand for the firm’s products.
G.
Elasticity and Total Revenue along a Linear Demand Curve
Figure 4
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1.
2.
The slope of a linear demand curve is constant, but the elasticity is not.
a.
At points with a low price and a high quantity demanded, demand is
inelastic.
b.
At points with a high price and a low quantity demanded, demand is
elastic.
Total revenue also varies at each point along the demand curve.
Note that when demand is elastic and price falls, total revenue rises. Also point out
that once demand is inelastic, any further decrease in price results in a decrease in
total revenue.
H.
I.
In the News: On the Road with Elasticity
1.
Students can often use information about price and quantity changes to develop
estimates of elasticity.
2.
This is an article from The Los Angeles Times that discusses the effects of price
changes on the quantity of gasoline demanded.
Other Demand Elasticities
1.
Definition of income elasticity of demand: a measure of how much the
quantity demanded of a good responds to a change in consumers’
Chapter 5/Elasticity and Its Application ) 99
income, computed as the percentage change in quantity demanded
divided by the percentage change in income.
a.
Formula
Income elasticity of demand =
b.
% change in quantity demanded
% change in income
Normal goods have positive income elasticities, while inferior goods have
negative income elasticities.
ALTERNATIVE CLASSROOM EXAMPLE:
John’s income rises from $20,000 to $22,000 and the quantity of hamburger he buys each
week falls from 2 pounds to 1 pound.
% change in quantity demanded = (1-2)/1.5 = -0.6667 = -66.67%
% change in income = (22,000-20,000)/21,000 = 0.0952 = 9.52%
income elasticity = 66.67%/9.52% = -7.00
Point out that hamburger is an inferior good for John.
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c.
2.
Necessities tend to have small income elasticities, while luxuries tend to
have large income elasticities.
Definition of cross-price elasticity of demand: a measure of how much
the quantity demanded of one good responds to a change in the price
of another good, computed as the percentage change in the quantity
demanded of the first good divided by the percentage change in the
price of the second good.
a.
Formula
Cross-price elasticity of demand =
b.
% change in quantity demanded of good 1
% change in price of good 2
Substitutes have positive cross-price elasticities, while complements have
negative cross-price elasticities.
ALTERNATIVE CLASSROOM EXAMPLE:
The price of apples rises from $1.00 per pound to $1.50 per pound. As a result, the quantity
of oranges demanded rises from 8,000 per week to 9,500.
% change in quantity of oranges demanded = (9,500-8,000)/8,750 = 0.1714 = 17.14%
% change in price of apples = (1.50-1.00)/1.25 = 0.40 = 40%
cross-price elasticity = 17.14%/40% = 0.43
Because the cross-price elasticity is positive, the two goods are substitutes.
Make sure that you explain to students why the signs of the income elasticity and the
cross-price elasticity matter. This will undoubtedly lead to some confusion because
we ignore the sign of the own-price elasticity of demand. You may want to put
together a table to present this distinction to students.
100 ) Chapter 5/Elasticity and Its Application
II.
The Elasticity of Supply
A.
B.
The Price Elasticity of Supply and Its Determinants
1.
Definition of price elasticity of supply: a measure of how much the
quantity supplied of a good responds to a change in the price of that
good, computed as the percentage change in quantity supplied divided
by the percentage change in price.
2.
Determinants of the Price Elasticity of Supply
a.
Flexibility of sellers: goods that are somewhat fixed in supply (beachfront
property) have inelastic supplies.
b.
Time horizon: supply is usually more inelastic in the short run than in the
long run.
Computing the Price Elasticity of Supply
1.
Formula
% change in quantity supplied
% change in price
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Price elasticity of supply =
2.
Example: the price of milk increases from $2.85 per gallon to $3.15 per gallon
and the quantity supplied rises from 9,000 to 11,000 gallons per month.
% change in price = (3.15 – 2.85)/3.00 × 100% = 10%
% change in quantity supplied = (11,000 - 9,000)/10,000 × 100% = 20%
Price elasticity of supply = (20%)/(10%) = 2
C.
The Variety of Supply Curves
Figure 5
1.
In general, the flatter the supply curve that passes through a given point, the
more elastic the supply.
Chapter 5/Elasticity and Its Application ) 101
2.
Extreme Cases
a.
When the elasticity is equal to zero, the supply is perfectly inelastic and
is a vertical line.
b.
When the elasticity is infinite, the supply is perfectly elastic and is a
horizontal line.
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Figure 6
3.
Because firms often have a maximum capacity for production, the elasticity of
supply may be very high at low levels of quantity supplied and very low at high
levels of quantity supplied.
Again, you may want to present several examples of goods that may have supply
curves like these.
III.
Three Applications of Supply, Demand, and Elasticity
A.
Can Good News for Farming Be Bad News for Farmers?
Figure 7
1.
A new hybrid of wheat is developed that is more productive than those used in
the past. What happens?
102 ) Chapter 5/Elasticity and Its Application
2.
Supply increases, price falls, and quantity demanded rises.
3.
If demand is inelastic, the fall in price is greater than the increase in quantity
demanded and total revenue falls.
4.
If demand is elastic, the fall in price is smaller than the rise in quantity
demanded and total revenue rises.
5.
In practice, the demand for basic foodstuffs (like wheat) is usually inelastic.
a.
This means less revenue for farmers.
b.
Because farmers are price takers, they still have the incentive to adopt
the new hybrid so that they can produce and sell more wheat.
c.
This may help explain why the number of farms has declined so
dramatically over the past two centuries.
d.
This may also explain why some government policies encourage farmers
to decrease the amount of crops planted.
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B.
Why Did OPEC Fail to Keep the Price of Oil High?
Figure 8
Short Run
C.
Figure 9
Long Run
1.
In the 1970s and 1980s, OPEC reduced the amount of oil it was willing to supply
to world markets. The decrease in supply led to an increase in the price of oil
and a decrease in quantity demanded. The increase in price was much larger in
the short run than the long run. Why?
2.
The demand and supply of oil are much more inelastic in the short run than the
long run. The demand is more elastic in the long run because consumers can
adjust to the higher price of oil by carpooling or buying a vehicle that gets better
mileage. The supply is more elastic in the long run because non-OPEC producers
will respond to the higher price of oil by producing more.
Does Drug Interdiction Increase or Decrease Drug-Related Crime?
Chapter 5/Elasticity and Its Application ) 103
1.
The federal government increases the number of federal agents devoted to the
war on drugs. What happens?
a.
The supply of drugs decreases, which raises the price and leads to a
reduction in quantity demanded. If demand is inelastic, total expenditure
on drugs (equal to total revenue) will increase. If demand is elastic, total
expenditure will fall.
b.
Thus, because the demand for drugs is likely to be inelastic, drug-related
crime may rise.
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2.
What happens if the government instead pursued a policy of drug education?
a.
The demand for drugs decreases, which lowers price and quantity
supplied. Total expenditure must fall (because both price and quantity
fall).
b.
Thus, drug education should not increase drug-related crime.
104 ) Chapter 5/Elasticity and Its Application
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can be found near the end of the textbook.
1.
The price elasticity of demand is a measure of how much the quantity demanded of a good
responds to a change in the price of that good, computed as the percentage change in quantity
demanded divided by the percentage change in price.
When demand is inelastic (a price elasticity less than 1), a price increase raises total revenue,
and a price decrease reduces total revenue. When demand is elastic (a price elasticity greater
than 1), a price increase reduces total revenue, and a price decrease increases total revenue.
When demand is unit elastic (a price elasticity equal to 1), a change in price does not affect total
revenue.
2.
The price elasticity of supply is a measure of how much the quantity supplied of a good responds
to a change in the price of that good, computed as the percentage change in quantity supplied
divided by the percentage change in price.
The price elasticity of supply might be different in the long run than in the short run because
over short periods of time, firms cannot easily change the sizes of their factories to make more or
less of a good. Thus, in the short run, the quantity supplied is not very responsive to the price.
However, over longer periods, firms can build new factories, expand existing factories, close old
factories, or they can enter or exit a market. So, in the long run, the quantity supplied can
respond substantially to a change in price.
3.
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A drought that destroys half of all farm crops could be good for farmers (at least those
unaffected by the drought) if the demand for the crops is inelastic. The shift to the left of the
supply curve leads to a price increase that will raise total revenue if the price elasticity of demand
is less than 1.
No one farmer would have an incentive to destroy his crops in the absence of a drought because
he takes the market price as given. Only if all farmers destroyed a portion of their crops
together, for example through a government program, would this plan work to make farmers
better off.
Questions for Review
1.
The price elasticity of demand measures how much quantity demanded responds to a change in
price. The income elasticity of demand measures how much quantity demanded responds to
changes in consumer income.
2.
The determinants of the price elasticity of demand include how available close substitutes are,
whether the good is a necessity or a luxury, how broadly defined the market is, and the time
horizon. Luxury goods have greater price elasticities than necessities, goods with close
substitutes have greater elasticities, goods in more narrowly defined markets have greater
elasticities, and the elasticity of demand is greater the longer the time horizon.
3.
An elasticity greater than one means that demand is elastic. When the elasticity is greater than
one, the percentage change in quantity demanded exceeds the percentage change in price.
When the elasticity equals zero, demand is perfectly inelastic. There is no change in quantity
demanded when there is a change in price.
Chapter 5/Elasticity and Its Application ) 105
4.
Figure 1 presents a supply-and-demand diagram, showing the equilibrium price, the equilibrium
quantity, and the total revenue received by producers. Total revenue equals the equilibrium price
times the equilibrium quantity, which is the area of the rectangle shown in the figure.
Figure 1
5.
6.
7.
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If demand is elastic, an increase in price reduces total revenue. With elastic demand, the quantity
demanded falls by a greater percentage than the price rises. As a result, total revenue declines.
A good with income elasticity less than zero is called an inferior good because as income rises,
the quantity demanded declines.
The price elasticity of supply is calculated as the percentage change in quantity supplied divided
by the percentage change in price. It measures how much quantity supplied responds to changes
in price.
8.
The price elasticity of supply of Picasso paintings is zero, because no matter how high price rises,
no more can ever be produced.
9.
The price elasticity of supply is usually larger in the long run than it is in the short run. Over short
periods of time, firms cannot easily change the sizes of their factories to make more or less of a
good, so the quantity supplied is not very responsive to price. Over longer periods, firms can
build new factories or close old ones, so the quantity supplied is more responsive to price.
10.
OPEC was unable to maintain a high price through the 1980s because the supply and demand
are more elastic in the long run than in the short run. When the price of oil rose, producers of oil
outside of OPEC increased oil exploration and built new extraction capacity. Consumers
responded with greater conservation efforts. As a result, supply increased and demand fell,
leading to a lower price for oil in the long run.
Problems and Applications
1.
a.
Mystery novels have more elastic demand than required textbooks, because mystery
novels have close substitutes and are a luxury good, while required textbooks are a
necessity with no close substitutes. If the price of mystery novels were to rise, readers
106 ) Chapter 5/Elasticity and Its Application
could substitute other types of novels, or buy fewer novels altogether. But if the price of
required textbooks were to rise, students would have little choice but to pay the higher
price. Thus, the quantity demanded of required textbooks is less responsive to price than
the quantity demanded of mystery novels.
2.
3.
4.
b.
Beethoven recordings have more elastic demand than classical music recordings in
general. Beethoven recordings are a narrower market than classical music recordings, so
it is easy to find close substitutes for them. If the price of Beethoven recordings were to
rise, people could substitute other classical recordings, like Mozart. But if the price of all
classical recordings were to rise, substitution would be more difficult (a transition from
classical music to rap is unlikely!). Thus, the quantity demanded of classical recordings is
less responsive to price than the quantity demanded of Beethoven recordings.
c.
Subway rides during the next five years have more elastic demand than subway rides
during the next six months. Goods have a more elastic demand over longer time
horizons. If the fare for a subway ride was to rise temporarily, consumers could not
switch to other forms of transportation without great expense or great inconvenience.
But if the fare for a subway ride was to remain high for a long time, people would
gradually switch to alternative forms of transportation. As a result, the quantity
demanded of subway rides during the next six months will be less responsive to changes
in the price than the quantity demanded of subway rides during the next five years.
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d.
Root beer has more elastic demand than water. Root beer is a luxury with close
substitutes, while water is a necessity with no close substitutes. If the price of water
were to rise, consumers have little choice but to pay the higher price. But if the price of
root beer were to rise, consumers could easily switch to other sodas. So the quantity
demanded of root beer is more responsive to changes in price than the quantity
demanded of water.
a.
For business travelers, the price elasticity of demand when the price of tickets rises from
$200 to $250 is [(2,000 – 1,900)/1,950]/[(250 – 200)/225] = 0.05/0.22 = 0.23. For
vacationers, the price elasticity of demand when the price of tickets rises from $200 to
$250 is [(800 – 600)/700] / [(250 – 200)/225] = 0.29/0.22 = 1.32.
b.
The price elasticity of demand for vacationers is higher than the elasticity for business
travelers because vacationers can choose more easily a different mode of transportation
(like driving or taking the train). Business travelers are less likely to do so because time is
more important to them and their schedules are less adaptable.
a.
The percentage change in price is equal to (2.20 – 1.00)/2.00 = 0.2 = 20%. If the price
elasticity of demand is 0.2, quantity demanded will fall by 4% in the short run [0.20 ×
0.20]. If the price elasticity of demand is 0.7, quantity demanded will fall by 14% in the
long run [0.7 × 0.2].
b.
Over time, consumers can make adjustments to their homes by purchasing alternative
heat sources such as natural gas or electric furnaces. Thus, they can respond more easily
to the change in the price of heating oil in the long run than in the short run.
a.
If your income is $10,000, your price elasticity of demand as the price of compact discs
rises from $8 to $10 is [(40 – 32)/36]/[(10 – 8)/9] =0.22/0.22 = 1. If your income is
$12,000, the elasticity is [(50 – 45)/47.5]/[(10 – 8)/9] = 0.11/0.22 = 0.5.
Chapter 5/Elasticity and Its Application ) 107
5.
6.
7.
8.
9.
b.
If the price is $12, your income elasticity of demand as your income increases from
$10,000 to $12,000 is [(30 – 24)/27]/[(12,000 – 10,000)/11,000] = 0.22/0.18 = 1.22. If
the price is $16, your income elasticity of demand as your income increases from
$10,000 to $12,000 is [(12 – 8)/10]/[(12,000 – 10,000)/11,000] = 0.40/0.18 = 2.2.
a.
If Emily always spends one-third of her income on clothing, then her income elasticity of
demand is one, because maintaining her clothing expenditures as a constant fraction of
her income means the percentage change in her quantity of clothing must equal her
percentage change in income.
b.
Emily's price elasticity of clothing demand is also one, because every percentage point
increase in the price of clothing would lead her to reduce her quantity purchased by the
same percentage.
c.
Because Emily spends a smaller proportion of her income on clothing, then for any given
price, her quantity demanded will be lower. Thus, her demand curve has shifted to the
left. Because she will again spend a constant fraction of her income on clothing, her
income and price elasticities of demand remain one.
a.
If quantity demanded falls by 4.3% when price rises by 20% , the price elasticity of
demand is 4.3/20 = 0.215, which is fairly inelastic.
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b.
Because the demand is inelastic, the Transit Authority's revenue rises when the fare
rises.
c.
The elasticity estimate might be unreliable because it is only the first month after the
fare increase. As time goes by, people may switch to other means of transportation in
response to the price increase. So the elasticity may be larger in the long run than it is in
the short run.
Tom's price elasticity of demand is zero, because he wants the same quantity regardless of the
price. Jerry's price elasticity of demand is one, because he spends the same amount on gas, no
matter what the price, which means his percentage change in quantity is equal to the percentage
change in price.
a.
With a price elasticity of demand of 0.4, reducing the quantity demanded of cigarettes by
20% requires a 50% increase in price, because 20/50 = 0.4. With the price of cigarettes
currently $2, this would require an increase in the price to $3.33 a pack using the
midpoint method (note that ($3.33 – $2)/$2.67 = .50).
b.
The policy will have a larger effect five years from now than it does one year from now.
The elasticity is larger in the long run, because it may take some time for people to
reduce their cigarette usage. The habit of smoking is hard to break in the short run.
c.
Because teenagers do not have as much income as adults, they are likely to have a
higher price elasticity of demand. Also, adults are more likely to be addicted to
cigarettes, making it more difficult to reduce their quantity demanded in response to a
higher price.
In order to determine whether you should raise or lower the price of admissions, you need to
know if the demand is elastic or inelastic. If demand is elastic, a decline in the price of
admissions will increase total revenue. If demand is inelastic, an increase in the price of
admissions will cause total revenue to rise.
108 ) Chapter 5/Elasticity and Its Application
10.
a.
As Figure 2 shows, the increase in supply reduces the equilibrium price and increases the
equilibrium quantity in both markets.
b.
In the market for pharmaceutical drugs (with inelastic demand), the increase in supply
leads to a relatively large decline in the equilibrium price and a small increase in the
equilibrium quantity.
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Figure 2
11.
c.
In the market for computers (with elastic demand), the increase in supply leads to a
relatively large increase in the equilibrium quantity and a small decline in the equilibrium
price.
d.
Because demand is inelastic in the market for pharmaceutical drugs, the percentage
increase in quantity will be lower than the percentage decrease in price; thus, total
consumer spending will decline. Because demand is elastic in the market for computers,
the percentage increase in quantity will be greater than the percentage decrease in price,
so total consumer spending will increase.
a.
As Figure 3 shows, the increase in demand increases both the equilibrium price and the
equilibrium quantity in both markets.
b.
In the market for beachfront resorts (with inelastic supply), the increase in demand leads
to a relatively large increase in the equilibrium price and a small increase in the
equilibrium quantity.
c.
In the market for automobiles (with elastic supply), the increase in demand leads to a
relatively large increase in the equilibrium quantity and a small increase in equilibrium
price.
d.
In both markets, total consumer spending rises, because both equilibrium price and
equilibrium quantity rise.
Chapter 5/Elasticity and Its Application ) 109
Figure 3
12.
a.
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b.
13.
Farmers whose crops were not destroyed benefited because the destruction of some of
the crops reduced the supply, causing the equilibrium price to rise.
To tell whether farmers as a group were hurt or helped by the floods, you would need to
know the price elasticity of demand. It could be that the total revenue received by all
farmers as a group actually rose.
A worldwide drought could increase the total revenue of farmers if the price elasticity of demand
for grain is inelastic. The drought reduces the supply of grain, but if demand is inelastic, the
reduction of supply causes a large increase in price. Total farm revenue would rise as a result. If
there is only a drought in Kansas, Kansas’ production is not a large enough proportion of the
total farm product to have much impact on the price. As a result, price does not change (or
changes by only a slight amount), while the output of Kansas farmers declines, thus reducing
their income.
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6
SUPPLY, DEMAND, AND
GOVERNMENT POLICIES
WHAT’S NEW IN THE FOURTH EDITION:
There is a new In the News box titled “Rent Control in New York City.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
¾
the effects of government policies that place a ceiling on prices.
¾
the effects of government policies that put a floor under prices.
¾
how a tax on a good affects the price of the good and the quantity sold.
¾
that taxes levied on buyers and taxes levied on sellers are equivalent.
¾
how the burden of a tax is split between buyers and sellers.
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CONTEXT AND PURPOSE:
Chapter 6 is the third chapter in a three-chapter sequence that deals with supply and demand and how
markets work. Chapter 4 developed the model of supply and demand. Chapter 5 added precision to the
model of supply and demand by developing the concept of elasticity—the sensitivity of the quantity
supplied and quantity demanded to changes in economic conditions. Chapter 6 addresses the impact of
government policies on competitive markets using the tools of supply and demand that you learned in
Chapters 4 and 5.
The purpose of Chapter 6 is to consider two types of government policies—price controls and
taxes. Price controls set the maximum or minimum price at which a good can be sold while a tax creates
a wedge between what the buyer pays and what the seller receives. These policies can be analyzed
within the model of supply and demand. We will find that government policies sometimes produce
unintended consequences.
111
112 ) Chapter 6/Supply, Demand, and Government Policies
KEY POINTS:
1. A price ceiling is a legal maximum on the price of a good or service. An example is rent control. If the
price ceiling is below the equilibrium price, the quantity demanded exceeds the quantity supplied.
Because of the resulting shortage, sellers must in some way ration the good or service among
buyers.
2. A price floor is a legal minimum on the price of a good or service. An example is the minimum wage.
If the price floor is above the equilibrium price, the quantity supplied exceeds the quantity
demanded. Because of the resulting surplus, buyers’ demands for the good or service must be
rationed in some way among sellers.
3. When the government levies a tax on a good, the equilibrium quantity of the good falls; that is, a tax
on a market shrinks the size of the market.
4. A tax on a good places a wedge between the price paid by buyers and the price received by sellers.
When the market moves to the new equilibrium, buyers pay more for the good and sellers receive
less for it. In this sense, buyers and sellers share the tax burden. The incidence of a tax (that is, the
division of the tax burden) does not depend on whether the tax is levied on buyers or sellers.
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5. The incidence of a tax depends on the price elasticities of supply and demand. The burden tends to
fall on the side of the market that is less elastic because that side of the market can respond less
easily to the tax by changing the quantity bought or sold.
CHAPTER OUTLINE:
I.
Controls on Prices
A.
Definition of price ceiling: a legal maximum on the price at which a good can be
sold.
B.
Definition of price floor: a legal minimum on the price at which a good can be
sold.
C.
How Price Ceilings Affect Market Outcomes
Figure 1
1.
There are two possible outcomes if a price ceiling is put into place in a market.
a.
If the price ceiling is higher than or equal to the equilibrium price, it is
not binding and has no effect on the price or quantity sold.
Chapter 6/Supply, Demand, and Government Policies ) 113
b.
2.
If the price ceiling is lower than the equilibrium price, the ceiling is a
binding constraint and a shortage is created.
If a shortage for a product occurs (and price cannot adjust to eliminate it), a
method for rationing the good must develop.
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3.
Not all buyers benefit from a price ceiling because some will be unable to
purchase the product.
4.
Case Study: Lines at the Gas Pump
Figure 2
a.
In 1973, OPEC raised the price of crude oil, which led to a reduction in
the supply of gasoline.
b.
The federal government put a price ceiling into place and this created
large shortages.
c.
Motorists were forced to spend large amounts of time in line at the gas
pump (which is how the gas was rationed).
d.
Eventually, the government realized its mistake and repealed the price
ceiling.
ALTERNATIVE CLASSROOM EXAMPLE:
Ask students about the rental market in their town. Draw a supply-and-demand graph for
two-bedroom apartments asking students what they believe the equilibrium rental rate is.
Then suggest that the city council is accusing landlords of taking advantage of students and
thus places a price ceiling below the equilibrium price. Make sure that students can see that a
shortage of apartments would result. Ask students to identify the winners and losers of this
government policy.
114 ) Chapter 6/Supply, Demand, and Government Policies
5.
Figure 3
6.
Case Study: Rent Control in the Short Run and Long Run
a.
The goal of rent control is to make housing more affordable for the poor.
b.
Because the supply of apartments is fixed (perfectly inelastic) in the
short run and upward sloping (elastic) in the long run, the shortage is
much larger in the long run than in the short run.
c.
Rent-controlled apartments are rationed in a number of ways including
long waiting lists, discrimination against minorities and families with
children, and even under-the-table payments to landlords.
d.
The quality of apartments also suffers due to rent control.
In the News: Rent Control in New York
a.
New York City has long had a system of rent control.
b.
This is an article from The Economist describing the impact of rent
controls in New York City.
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D.
How Price Floors Affect Market Outcomes
1.
Figure 4
There are two possible outcomes if a price floor is put into place in a market.
a.
If the price floor is lower than or equal to the equilibrium price, it is not
binding and has no effect on the price or quantity sold.
b.
If the price floor is higher than the equilibrium price, the floor is a
binding constraint and a surplus is created.
ALTERNATIVE CLASSROOM EXAMPLE:
Go through an example with an agricultural price support. Show students that, even though a
price support is not a legal minimum price, its result is exactly the same as a price floor.
Make sure that students can see that a surplus will result. Ask students to identify the
winners and losers of this government policy. Make sure that you also point out the costs of
the program (purchasing the surplus and storing it).
Chapter 6/Supply, Demand, and Government Policies ) 115
2.
Figure 5
E.
Case Study: The Minimum Wage
a.
The market for labor looks like any other market: downward-sloping
demand, upward-sloping supply, an equilibrium price (called a wage),
and an equilibrium quantity of labor hired.
b.
If the minimum wage is above the equilibrium wage in the labor market,
a surplus of labor will develop (unemployment).
c.
The minimum wage will be a binding constraint only in markets where
equilibrium wages are low.
d.
Thus, the minimum wage will have its greatest impact on the market for
teenagers and other unskilled workers.
Evaluating Price Controls
1.
Because most economists feel that markets are usually a good way to organize
economic activity, most oppose the use of price ceilings and floors.
a.
Prices balance supply and demand and thus coordinate economic
activity.
b.
If prices are set by laws, they obscure the signals that efficiently allocate
scarce resources.
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This is a good chance to reinforce the principle “Markets are usually a good way to
organize economic activity.”
2.
Price ceilings and price floors often hurt the people they are intended to help.
a.
Rent controls create a shortage of quality housing and provide
disincentives for building maintenance.
b.
Minimum wage laws create higher rates of unemployment for teenage
and low skilled workers.
Be prepared to answer the question, “If price controls have such adverse
consequences, why are they imposed?” You may want to point out that, sometimes,
economic ignorance leads to unintended outcomes. You may also want to point out
that economic analysis serves as only a guide to policymakers. They may choose to
ignore it when forming policy. In addition, it is often interesting to encourage the
students to think about the distributional effects of these government programs.
116 ) Chapter 6/Supply, Demand, and Government Policies
Activity 1—Ducks in a Row
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Price ceilings, subsidies, and unintended consequences
2 toy ducks, some play money, 3 volunteers
10 minutes
Works in any size class
Purpose
This demonstration illustrates some common problems of government intervention in
markets.
Instructions
One volunteer plays the role of the government in a poor country. Give the play money to the
“government,” except for $1. The government uses this money to buy ducks from the farmer
and provides the ducks to the shopkeeper. The second volunteer is an urban shopkeeper. The
shopkeeper asks the government for more ducks whenever he or she is sold out. Give the
shopkeeper one duck. The third volunteer is a consumer. The consumer buys ducks. Give the
consumer $1 in play money. The instructor is a duck farmer. The farmer keeps the second
duck.
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Explain this background: “Ducks are a staple food in this country but they are expensive at $3
each. The government wants to make food cheap for the urban poor to alleviate hunger.
They calculate people could afford ducks if they were priced at $1. The government decides
to impose a price ceiling of $1; $1 is now the maximum retail price for ducks.”
Start the game. The consumer buys one duck from the shopkeeper. The shopkeeper requests
more ducks from the government. The government comes to the farmer.
Points for Discussion
The instructor, as the duck farmer, controls the game. There are three points to make in this
demonstration:
1.
Shortage. The farmer refuses to sell ducks at $1 each. The shopkeeper has no ducks.
2.
Subsidy. The farmer offers to sell the ducks for $3. The ducks can then be sold in the
marketplace for $1. The government pays a $2 subsidy to keep food prices low.
3.
Black markets. After the farmer sells the duck to the government for $3, the duck
goes to the shopkeeper for $1. The farmer buys back the original duck for $1 and
resells it to the government for $3. This can continue until the government runs out
of money.
Government intervention in markets can have unintended consequences. The price ceiling
initially decreased the amount of food available in the cities. Subsidies to producers can
increase production, but subsidies create new incentives.
II.
Taxes
A.
Definition of tax incidence: the manner in which the burden of a tax is shared
among participants in a market.
B.
How Taxes on Buyers Affect Market Outcomes
Chapter 6/Supply, Demand, and Government Policies ) 117
Use this chance to reinforce the three steps learned in Chapter 4. Students should
decide whether this tax law affects the demand curve or the supply curve, decide
which way it shifts, and then examine how the shift affects equilibrium price and
quantity.
1.
If the government requires the buyer to pay a certain dollar amount for each unit
of a good purchased, this will cause a decrease in demand.
Figure 6
Examples of unit taxes include most government excise taxes on products such as
gasoline, alcohol, and tobacco.
2.
The demand curve will shift down by the amount of the tax.
You will want to be very careful when discussing the “downward” shift of the demand
curve given that we encourage students to think of supply and demand curves
shifting “right” and “left.”
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3.
The quantity of the good sold will decline.
4.
Buyers and sellers will share the burden of the tax; buyers pay more for the
good (including the tax) and sellers receive less.
5.
Two lessons can be learned here.
a.
Taxes discourage market activity.
b.
Buyers and sellers share the burden of a tax.
118 ) Chapter 6/Supply, Demand, and Government Policies
C.
How Taxes on Sellers Affect Market Outcomes
Figure 7
1.
If the government requires the seller to pay a certain dollar amount for each unit
of a good sold, this will cause a decrease in supply.
2.
The supply curve will shift up by the amount of the tax.
Again, be very careful when discussing the “upward” shift of the supply curve.
Students often mistakenly believe that this means that supply is increasing. Point out
the increase in the cost of selling the good. If students understand that an increase
in cost leads to a decrease in supply, they will be less likely to become confused.
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3.
The quantity of the good sold will decline.
4.
Buyers and sellers will share the burden of the tax; buyers pay more for the
good and sellers receive less (because of the tax).
Stress that the outcome of a tax levied on sellers is exactly the same as the outcome
of a tax levied on buyers. When drawing this in class, make sure that the price that
buyers end up paying and the price that sellers end up receiving is the same in both
examples.
D.
Case Study: Can Congress Distribute the Burden of a Payroll Tax?
Figure 8
1.
FICA (Social Security) taxes were designed so that firms and workers would
equally share the burden of the tax.
2.
This type of payroll tax will simply put a wedge between the wage the firm pays
and the wage the workers will receive.
Chapter 6/Supply, Demand, and Government Policies ) 119
3.
It is true that firms and workers share the burden of this tax, but it is not
necessarily 50-50.
Go through this material slowly. Make sure that students can see how to find the
burden of the tax paid by consumers and the burden of the tax paid by producers
before discussing the effects of elasticity on tax incidence. If you rush through this
material, you will lose them.
E.
Elasticity and Tax Incidence
1.
When supply is elastic and demand is inelastic, the largest share of the tax
burden falls on consumers.
2.
When supply is inelastic and demand is elastic, the largest share of the tax
burden falls on producers.
3.
In general, a tax burden falls more heavily on the side of the market that is less
elastic.
a.
A small elasticity of demand means that buyers do not have good
alternatives to consuming this product.
b.
A small elasticity of supply means that sellers do not have good
alternatives to producing this particular good.
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Figure 9
4.
Case Study: Who Pays the Luxury Tax?
a.
In 1990, Congress adopted a new luxury tax.
b.
The goal of the tax was to raise revenue from those who could most
easily afford to pay.
120 ) Chapter 6/Supply, Demand, and Government Policies
c.
Because the demand for luxuries is often relatively more elastic than
supply, the burden of the tax fell on producers and their workers.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can be found near the end of the textbook.
1.
A price ceiling is a legal maximum on the price at which a good can be sold. Examples of price
ceilings include rent controls, price controls on gasoline in the 1970s, and price ceilings on water
during a drought. A price floor is a legal minimum on the price at which a good can be sold.
Examples of price floors include the minimum wage and farm price supports. A price ceiling
leads to a shortage, if the ceiling is binding, because suppliers will not produce enough goods to
meet demand. A price floor leads to a surplus, if the floor is binding, because suppliers produce
more goods than are demanded.
2.
With no tax, as shown in Figure 1, the demand curve is D1 and the supply curve is S. The
equilibrium price is P1 and the equilibrium quantity is Q1. If the tax is imposed on car buyers, the
demand curve shifts downward by the amount of the tax ($1,000) to D2. The downward shift in
the demand curve leads to a decline in the price received by sellers to P2 and a decline in the
equilibrium quantity to Q2. The price received by sellers declines by P1 – P2, shown in the figure
as ∆PS. Buyers pay a total of P2 + $1,000, an increase in what they pay of (P2 + $1,000) – P1,
shown in the figure as ∆PB.
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Figure 1
If the tax is imposed on car sellers, as shown in Figure 2, the supply curve shifts upward by the
amount of the tax ($1,000) to S2. The upward shift in the supply curve leads to a rise in the
price paid by buyers to P2 and a decline in the equilibrium quantity to Q2. The price paid by
buyers increases by P2 – P1, shown in the figure as ∆PB. Sellers receive P2 – 1,000, a decrease in
what they receive by P1 – (P2 – $1,000), shown in the figure as ∆PS.
Chapter 6/Supply, Demand, and Government Policies ) 121
Figure 2
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Questions for Review
1.
2.
3.
An example of a price ceiling is the rent control system in New York City. An example of a price
floor is the minimum wage. Many other examples are possible.
A shortage of a good arises when there is a binding price ceiling. A surplus of a good arises when
there is a binding price floor.
When the price of a good is not allowed to bring supply and demand into equilibrium, some
alternative mechanism must allocate resources. If quantity supplied exceeds quantity demanded,
so that there is a surplus of a good as in the case of a binding price floor, sellers may try to
appeal to the personal biases of the buyers. If quantity demanded exceeds quantity supplied, so
that there is a shortage of a good as in the case of a binding price ceiling, sellers can ration the
good according to their personal biases, or make buyers wait in line.
4.
Economists usually oppose controls on prices because prices have the crucial job of coordinating
economic activity by balancing demand and supply. When policymakers set controls on prices,
they obscure the signals that guide the allocation of society’s resources. Furthermore, price
controls often hurt those they are trying to help.
5.
Removing a tax paid by buyers and replacing it with a tax paid by sellers has no effect on the
price that buyers pay, the price that sellers receive, and the quantity of the good sold.
6.
A tax on a good raises the price buyers pay, lowers the price sellers receive, and reduces the
quantity sold.
7.
The burden of a tax is divided between buyers and sellers depending on the elasticity of demand
and supply. Elasticity represents the willingness of buyers or sellers to leave the market, which in
turns depends on their alternatives. When a good is taxed, the side of the market with fewer
good alternatives cannot easily leave the market and thus bears more of the burden of the tax.
122 ) Chapter 6/Supply, Demand, and Government Policies
Problems and Applications
1.
If the price ceiling of $40 per ticket is below the equilibrium price, then quantity demanded
exceeds quantity supplied, so there will be a shortage of tickets. The policy decreases the
number of people who attend classical music concerts, because the quantity supplied is lower
because of the lower price.
2.
a.
The imposition of a binding price floor in the cheese market is shown in Figure 3. In the
absence of the price floor, the price would be P1 and the quantity would be Q1. With the
floor set at Pf, which is greater than P1, the quantity demanded is Q2, while quantity
supplied is Q3, so there is a surplus of cheese in the amount Q3 – Q2.
b.
The farmers’ complaint that their total revenue has declined is correct if demand is
elastic. With elastic demand, the percentage decline in quantity would exceed the
percentage rise in price, so total revenue would decline.
c.
If the government purchases all the surplus cheese at the price floor, producers benefit
and taxpayers lose. Producers would produce quantity Q3 of cheese, and their total
revenue would increase substantially. However, consumers would buy only quantity Q2 of
cheese, so they are in the same position as before. Taxpayers lose because they would
be financing the purchase of the surplus cheese through higher taxes.
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Figure 3
3.
4.
a.
The equilibrium price of Frisbees is $8 and the equilibrium quantity is six million Frisbees.
b.
With a price floor of $10, the new market price is $10 because the price floor is binding.
At that price, only two million Frisbees are sold, because that is the quantity demanded.
c.
If there’s a price ceiling of $9, it has no effect, because the market equilibrium price is
$8, which is below the ceiling. So the market price is $8 and the quantity sold is six
million Frisbees.
a.
Figure 4 shows the market for beer without the tax. The equilibrium price is P1 and the
equilibrium quantity is Q1. The price paid by consumers is the same as the price received
Chapter 6/Supply, Demand, and Government Policies ) 123
by producers.
Figure 4
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b.
5.
Figure 5
When the tax is imposed, it drives a wedge of $2 between supply and demand, as shown
in Figure 5. The price paid by consumers is P2, while the price received by producers is
P2 – $2. The quantity of beer sold declines to Q2.
Reducing the payroll tax paid by firms and using part of the extra revenue to reduce the payroll
tax paid by workers would not make workers better off, because the division of the burden of a
tax depends on the elasticity of supply and demand and not on who must pay the tax. Because
the tax wedge would be larger, it is likely that both firms and workers, who share the burden of
any tax, would be worse off.
6.
If the government imposes a $500 tax on luxury cars, the price paid by consumers will rise less
than $500, in general. The burden of any tax is shared by both producers and consumers⎯the
price paid by consumers rises and the price received by producers falls, with the difference
between the two equal to the amount of the tax. The only exceptions would be if the supply
curve were perfectly elastic or the demand curve were perfectly inelastic, in which case
consumers would bear the full burden of the tax and the price paid by consumers would rise by
exactly $500.
7.
a.
It does not matter whether the tax is imposed on producers or consumers⎯the effect
will be the same. With no tax, as shown in Figure 6, the demand curve is D1 and the
supply curve is S1. If the tax is imposed on producers, the supply curve shifts up by the
amount of the tax (50 cents) to S2. Then the equilibrium quantity is Q2, the price paid by
consumers is P2, and the price received (after taxes are paid) by producers is P2 – 50
cents. If the tax is instead imposed on consumers, the demand curve shifts down by the
amount of the tax (50 cents) to D2. The downward shift in the demand curve (when the
tax is imposed on consumers) is exactly the same magnitude as the upward shift in the
supply curve when the tax is imposed on producers. So again, the equilibrium quantity is
Q2, the price paid by consumers is P2 (including the tax paid to the government), and the
price received by producers is P2 – 50 cents.
124 ) Chapter 6/Supply, Demand, and Government Policies
Figure 6
b.
The more elastic the demand curve is, the more effective this tax will be in reducing the
quantity of gasoline consumed. Greater elasticity of demand means that quantity falls
more in response to the rise in the price of gasoline. Figure 7 illustrates this result.
Demand curve D1 represents an elastic demand curve, while demand curve D2 is more
inelastic. The tax will cause a greater decline in the quantity sold when demand is elastic.
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Figure 7
8.
c.
The consumers of gasoline are hurt by the tax because they get less gasoline at a higher
price.
d.
Workers in the oil industry are hurt by the tax as well. With a lower quantity of gasoline
being produced, some workers may lose their jobs. With a lower price received by
producers, wages of workers might decline.
a.
Figure 8 shows the effects of the minimum wage. In the absence of the minimum wage,
the market wage would be w1 and Q1 workers would be employed. With the minimum
Chapter 6/Supply, Demand, and Government Policies ) 125
wage (wm) imposed above w1, the market wage is wm, the number of employed workers
is Q2, and the number of workers who are unemployed is Q3 - Q2. Total wage payments
to workers are shown as the area of rectangle ABCD, which equals wm times Q2.
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Figure 8
b.
An increase in the minimum wage would decrease employment. The size of the effect on
employment depends only on the elasticity of demand. The elasticity of supply does not
matter, because there is a surplus of labor.
c.
The increase in the minimum wage would increase unemployment. The size of the rise in
unemployment depends on both the elasticities of supply and demand. The elasticity of
demand determines the change in the quantity of labor demanded, the elasticity of
supply determines the change in the quantity of labor supplied, and the difference
between the quantities supplied and demanded of labor is the amount of unemployment.
d.
If the demand for unskilled labor were inelastic, the rise in the minimum wage would
increase total wage payments to unskilled labor. With inelastic demand, the percentage
decline in employment would be lower than the percentage increase in the wage, so total
wage payments increase. However, if the demand for unskilled labor were elastic, total
wage payments would decline, because then the percentage decline in employment
would exceed the percentage increase in the wage.
126 ) Chapter 6/Supply, Demand, and Government Policies
9.
a.
Figure 9 shows the effect of a tax on gun buyers. The tax reduces the demand for guns
from D1 to D2. The result is a rise in the price buyers pay for guns from P1 to P2, and a
decline in the quantity of guns from Q1 to Q2.
Figure 9
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b.
Figure 10 shows the effect of a tax on gun sellers. The tax reduces the supply of guns
from S1 to S2. The result is a rise in the price buyers pay for guns from P1 to P2, and a
decline in the quantity of guns from Q1 to Q2.
Figure 10
Chapter 6/Supply, Demand, and Government Policies ) 127
c.
Figure 11 shows the effect of a binding price floor on guns. The increase in price from P1
to Pf leads to a decline in the quantity of guns from Q1 to Q2. There is excess supply in
the market for guns, because the quantity supplied (Q3) exceeds the quantity demanded
(Q2) at the price Pf.
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Figure 11
d.
Figure 12 shows the effect of a tax on ammunition. The tax on ammunition reduces the
demand for guns from D1 to D2, because ammunition and guns are complements. The
result is a decline in the price of guns from P1 to P2, and a decline in the quantity of guns
from Q1 to Q2.
Figure 12
128 ) Chapter 6/Supply, Demand, and Government Policies
10.
a.
Programs aimed at making the public aware of the dangers of smoking reduce the
demand for cigarettes, shown in Figure 13 as a shift from demand curve D1 to D2. The
price support program increases the price of tobacco, which is the main ingredient in
cigarettes. As a result, the supply of cigarettes shifts to the left, from S1 to S2. The effect
of both programs is to reduce the quantity of cigarette consumption from Q1 to Q2.
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Figure 13
11.
b.
The combined effect of the two programs on the price of cigarettes is ambiguous. The
education campaign reduces demand for cigarettes, which tends to reduce the price. The
tobacco price supports raising the cost of production of cigarettes, which tends to
increase the price.
c.
The taxation of cigarettes further reduces cigarette consumption, because it increases
the price to consumers. As shown in the figure, the quantity falls to Q3.
a.
The effect of a $0.50 per cone subsidy is to shift the demand curve up by $0.50 at each
quantity, because at each quantity a consumer's willingness to pay is $0.50 higher. The
effects of such a subsidy are shown in Figure 14. Before the subsidy, the price is P1. After
the subsidy, the price received by sellers is PS and the effective price paid by consumers
is PD, which equals PS minus $0.50. Before the subsidy, the quantity of cones sold is Q1;
after the subsidy the quantity increases to Q2.
Chapter 6/Supply, Demand, and Government Policies ) 129
Figure 14
b.
Because of the subsidy, consumers are better off, because they consume more at a
lower price. Producers are also better off, because they sell more at a higher price. The
government loses, because it has to pay for the subsidy.
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rkets
7
CONSUMERS, PRODUCERS, AND
THE EFFICIENCY OF MARKETS
WHAT’S NEW IN THE FOURTH EDITION:
There is a new, clearer explanation of the transition from stepped to smooth demand curves. The
decision of why free markets produce the quantity of goods and services that maximizes the sum of
consumer and producer surplus has been augmented and clarified. There is a new In the News box that
gives thanks for the “invisible hand” of the marketplace.
LEARNING OBJECTIVES:
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By the end of this chapter, students should understand:
¾
the link between buyers’ willingness to pay for a good and the demand curve.
¾
how to define and measure consumer surplus.
¾
the link between sellers’ costs of producing a good and the supply curve.
¾
how to define and measure producer surplus.
¾
that the equilibrium of supply and demand maximizes total surplus in a market.
CONTEXT AND PURPOSE:
Chapter 7 is the first chapter in a three-chapter sequence on welfare economics and market efficiency.
Chapter 7 employs the supply and demand model to develop consumer surplus and producer surplus as a
measure of welfare and market efficiency. These concepts are then utilized in Chapters 8 and 9 to
determine the winners and losers from taxation and restrictions on international trade.
The purpose of Chapter 7 is to develop welfare economics—the study of how the allocation of
resources affects economic well-being. Chapters 4 through 6 employed supply and demand in a positive
framework, which focused on the question, “What is the equilibrium price and quantity in a market?” This
chapter now addresses the normative question, “Is the equilibrium price and quantity in a market the
best possible solution to the resource allocation problem, or is it simply the price and quantity that
balance supply and demand?” Students will discover that under most circumstances the equilibrium price
and quantity is also the one that maximizes welfare.
131
132 ) Chapter 7/Consumers, Producers, and the Efficiency of Markets
KEY POINTS:
1. Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay
for it, and it measures the benefit buyers get from participating in a market. Consumer surplus can
be computed by finding the area below the demand curve and above the price.
2. Producer surplus equals the amount sellers receive for their goods minus their costs of production,
and it measures the benefit sellers get from participating in a market. Producer surplus can be
computed by finding the area below the price and above the supply curve.
3. An allocation of resources that maximizes the sum of consumer and producer surplus is said to be
efficient. Policymakers are often concerned with the efficiency, as well as the equity, of economic
outcomes.
4. The equilibrium of supply and demand maximizes the sum of consumer and producer surplus. That
is, the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently.
5. Markets do not allocate resources efficiently in the presence of market failures such as market power
or externalities.
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CHAPTER OUTLINE:
I.
Definition of welfare economics: the study of how the allocation of resources affects
economic well-being.
Students often are confused by the use of the word “welfare.” Remind them that we
are talking about well-being and not public assistance.
II.
Consumer Surplus
A.
Willingness to Pay
1.
Definition of willingness to pay: the maximum amount that a buyer will
pay for a good.
2.
Example: You are auctioning a mint-condition recording of Elvis Presley’s first
album. Four buyers show up. Their willingness to pay is as follows:
Students will understand consumer surplus if you take the time to work through the
Elvis Presley example. If you start with this simple example, students will have no
trouble understanding how to find consumer surplus on a graph.
Table 1
Chapter 7/Consumers, Producers, and the Efficiency of Markets ) 133
Buyer
John
Paul
George
Ringo
Willingness to Pay
$100
$80
$70
$50
If the bidding goes to slightly higher than $80, all buyers drop out except for
John. Because John is willing to pay more than he has to for the album, he
derives some benefit from participating in the market.
3.
Definition of consumer surplus: the amount a buyer is willing to pay for a
good minus the amount the buyer actually pays for it.
4.
Note that if you had more than one copy of the album, the price in the auction
would end up being lower (a little over $70 in the case of two albums) and both
John and Paul would gain consumer surplus.
Activity 1—Value of a Time Machine
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Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Consumer surplus
None
10 minutes
Works in any size class
Purpose
Consumer surplus can be a hard concept for students because it is based on avoided expense
rather than on money that is actually exchanged. This example puts a specific dollar value on
consumer surplus.
Instructions
Tell the class, “A new technology has been developed that allows individuals to travel
backward or forward in time. We want to identify the value this time machine provides to
consumers. Let’s assume the four consumers who most desire this product are in this class.”
Choose four student names and use them in the following example:
“Scott is the consumer who most values this product. He wants to go back to the time
of the dinosaurs. He is willing to pay $3,000.”
“Carol is the consumer with the next highest willingness to pay. She would like to see
200 years in the future. She’d pay $2,500.”
“Steve is the next highest bidder. He’d like to relive this entire semester. He’ll pay up
to $800.”
“Jeanne is our fourth consumer. She’d pay $200 to move the clock forward to the end
of this class period.”
On the board write:
Scott
Carol
Steve
Jeanne
$3,000
$2,500
$800
$200
134 ) Chapter 7/Consumers, Producers, and the Efficiency of Markets
“This represents the demand curve for the time machine. Consumer surplus is the difference
between what consumers are willing to pay and the amount they actually have to pay. The
market price will determine who uses the time machine and how much surplus they keep.”
“If the price of a time machine ride was $500, three rides would be sold—one to Scott, one to
Carol, and one to Steve. Jeanne is not willing to pay $500, so she wouldn’t time travel.”
“We can calculate the consumer surplus of three time trips. Scott would pay $3,000 but only
pays $500, leaving $2,500 of net benefits.” (Put these numbers on the board.) “Carol has net
benefits of $2,000. Steve has $300 in net benefits. Adding up these net savings gives $4,800
in consumer surplus.”
Points for Discussion
The consumer surplus depends on a good’s selling price and the number of consumers who
are willing to purchase the good at that price. The lower the price, the greater the consumer
surplus.
B.
Using the Demand Curve to Measure Consumer Surplus
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1.
We can use the information on willingness to pay to derive a demand curve for
the rare Elvis Presley album.
Price
More than $100
$80 to $100
$70 to $80
$50 to $70
$50 or less
Buyers
None
John
John, Paul
John, Paul, George
John, Paul, George, Ringo
Quantity Demanded
0
1
2
3
4
Figure 1
2.
At any given quantity, the price given by the demand curve reflects the
willingness to pay of the marginal buyer. Because the demand curve shows the
Chapter 7/Consumers, Producers, and the Efficiency of Markets ) 135
buyers’ willingness to pay, we can use the demand curve to measure consumer
surplus.
Figure 2
3.
C.
Consumer surplus can be measured as the area below the demand curve and
above the price.
How a Lower Price Raises Consumer Surplus
Figure 3
1.
As price falls, consumer surplus increases for two reasons.
a.
Those already buying the product will receive additional consumer
surplus because they are paying less for the product than before (area A
on the graph).
b.
Because the price is now lower, some new buyers will enter the market
and receive consumer surplus on these additional units of output
purchased (area B on the graph).
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D.
What Does Consumer Surplus Measure?
It is important to stress that consumer surplus is measured in monetary terms.
Consumer surplus gives us a way to place a monetary cost on inefficient market
outcomes (due to government involvement or market failure).
1.
Remember that consumer surplus is the difference between the amount that
buyers are willing to pay for a good and the price that they actually pay.
2.
Thus, it measures the benefit that consumers receive from the good as the
buyers themselves perceive it.
136 ) Chapter 7/Consumers, Producers, and the Efficiency of Markets
ALTERNATIVE CLASSROOM EXAMPLE:
Review the material on price ceilings from Chapter 6. Redraw the market for two-bedroom
apartments in your town. Draw in a price ceiling below the equilibrium price.
Then go through:
ƒ consumer surplus before the price ceiling is put into place.
ƒ consumer surplus after the price ceiling is put into place.
III.
Producer Surplus
A.
Cost and the Willingness to Sell
1.
Definition of cost: the value of everything a seller must give up to
produce a good.
You will need to take some time to explain the relationship between the producers’
willingness to sell and the cost of producing the good. The relationship between cost
and the supply curve is not as apparent as the relationship between the demand
curve and willingness to pay.
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2.
Example: You want to hire someone to paint your house. You accept bids for the
work from four sellers. Each painter is willing to work if the price you will pay
exceeds her opportunity cost. (Note that this opportunity cost thus represents
willingness to sell.) The costs are:
Seller
Mary
Frida
Georgia
Grandma
Cost
$900
$800
$600
$500
Table 2
3.
Bidding will stop when the price gets to be slightly below $600. All sellers will
drop out except for Grandma. Because Grandma receives more than she would
require to paint the house, she derives some benefit from producing in the
market.
4.
Definition of producer surplus: the amount a seller is paid for a good
minus the seller’s cost of providing it.
5.
Note that if you had more than one house to paint, the price in the auction
would end up being higher (a little under $800 in the case of two houses) and
both Grandma and Georgia would gain producer surplus.
Chapter 7/Consumers, Producers, and the Efficiency of Markets ) 137
B.
Using the Supply Curve to Measure Producer Surplus
1.
We can use the information on cost (willingness to sell) to derive a supply curve
for house painting services.
Price
$900 or more
$800 to $900
$600 to $800
$500 to $600
less than $500
2.
Sellers
Mary, Frida, Georgia, Grandma
Frida, Georgia, Grandma
Georgia, Grandma
Grandma
None
Quantity Supplied
4
3
2
1
0
At any given quantity, the price given by the supply curve represents the cost of
the marginal seller. Because the supply curve shows the sellers’ cost (willingness
to sell), we can use the supply curve to measure producer surplus.
Figure 4
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Figure 5
3.
Producer surplus can be measured as the area above the supply curve and below
the price.
138 ) Chapter 7/Consumers, Producers, and the Efficiency of Markets
C.
How a Higher Price Raises Producer Surplus
Figure 6
1.
As price rises, producer surplus increases for two reasons.
a.
Those already selling the product will receive additional producer surplus
because they are receiving more for the product than before (area C on
the graph).
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b.
D.
Because the price is now higher, some new sellers will enter the market
and receive producer surplus on these additional units of output sold
(area D on the graph).
Producer surplus is used to measure the economic well-being of producers, much like
consumer surplus is used to measure the economic well-being of consumers.
ALTERNATIVE CLASSROOM EXAMPLE:
Review the material on price floors from Chapter 6. Redraw the market for an agricultural
product such as corn. Draw in a price support above the equilibrium price.
Then go through:
ƒ producer surplus before the price support is put in place.
ƒ producer surplus after the price support is put in place.
Make sure that you discuss the cost of the price support to taxpayers.
IV.
Market Efficiency
A.
The Benevolent Social Planner
1.
The economic well-being of everyone in society can be measured by total
surplus, which is the sum of consumer surplus and producer surplus:
Total Surplus = Consumer Surplus + Producer Surplus
Chapter 7/Consumers, Producers, and the Efficiency of Markets ) 139
Total Surplus = (Value to Buyers – Amount Paid by Buyers) +
(Amount Received by Sellers – Cost to Sellers)
Because the Amount Paid by Buyers = Amount Received by
Sellers:
Total Surplus = Value to Buyers − Cost to Sellers
2.
Definition of efficiency: the property of a resource allocation of
maximizing the total surplus received by all members of society.
3.
Definition of equity: the fairness of the distribution of well-being among
the members of society.
Now might be a good time to point out that many government policies involve a
trade-off between efficiency and equity. When you evaluate government policies, like
price ceilings or floors, you can explain them in terms of equity and efficiency.
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B.
Evaluating the Market Equilibrium
Figure 7
1.
At the market equilibrium price:
a.
Buyers who value the product more than the equilibrium price will
purchase the product; those who do not, will not purchase the product.
In other words, the free market allocates the supply of a good to the
buyers who value it most highly, as measured by their willingness to pay.
140 ) Chapter 7/Consumers, Producers, and the Efficiency of Markets
b.
2.
Sellers whose costs are lower than the equilibrium price will produce the
product; those whose costs are higher, will not produce the product. In
other words, the free market allocates the demand for goods to the
sellers who can produce it at the lowest cost.
Total surplus is maximized at the market equilibrium.
Figure 8
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3.
a.
At any quantity of output smaller than the equilibrium quantity, the value
of the product to the marginal buyer is greater than the cost to the
marginal seller so total surplus would rise if output increases.
b.
At any quantity of output greater than the equilibrium quantity, the value
of the product to the marginal buyer is less than the cost to the marginal
seller so total surplus would rise if output decreases.
Note that this is one of the reasons that economists believe Principle #6: Markets
are usually a good way to organize economic activity.
It would be a good idea to remind students that there are circumstances when the
market process does not lead to the most efficient outcome. Examples include
situations such as when a firm (or buyer) has market power over price or when there
are externalities present. These situations will be discussed in later chapters.
C.
In the News: Ticket Scalping
1.
Ticket scalping is an example of how markets work to achieve an efficient
outcome.
2.
This article concerns the debate over legalizing ticket scalping.
Chapter 7/Consumers, Producers, and the Efficiency of Markets ) 141
D.
Case Study: Should There Be a Market in Organs?
1.
2.
E.
V.
As a matter of public policy, people are not allowed to sell their organs.
a.
In essence, this means that there is a price ceiling on organs of $0.
b.
This has led to a shortage of organs.
The creation of a market for organs would lead to a more efficient allocation of
resources, but critics worry about the equity of a market system for organs.
In the News: The Miracle of the Market
1.
The market system allows many Americans to enjoy a bountiful feast for
Thanksgiving.
2.
This is an opinion column from The Boston Globe suggesting that individuals give
thanks for the economic system when sitting down to Thanksgiving dinner.
Market Efficiency and Market Failure
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A.
To conclude that markets are efficient, we made several assumptions about how markets
worked.
1.
Perfectly competitive markets.
2.
No externalities.
B.
When these assumptions do not hold, the market equilibrium may not be efficient.
C.
When markets fail, public policy can potentially remedy the situation.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can be found near the end of the textbook.
1.
Figure 1 (on the next page) shows the demand curve for turkey. The price of turkey is P1 and
the consumer surplus that results from that price is denoted CS. Consumer surplus is the
amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. It
measures the benefit to buyers of participating in a market.
142 ) Chapter 7/Consumers, Producers, and the Efficiency of Markets
Figure 1
2.
Figure 2
Figure 2 shows the supply curve for turkey. The price of turkey is P1 and the producer surplus
that results from that price is denoted PS. Producer surplus is the amount sellers are paid for a
good minus the sellers’ cost of providing it (measured by the supply curve). It measures the
benefit to sellers of participating in a market.
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Figure 3
3.
Figure 3 shows the supply and demand for turkey. The price of turkey is P1, consumer surplus is
CS, and producer surplus is PS. Producing more turkeys than the equilibrium quantity would
lower total surplus because the value to the marginal buyer would be lower than the cost to the
marginal seller on those additional units.
Chapter 7/Consumers, Producers, and the Efficiency of Markets ) 143
Questions for Review
1.
The price a buyer is willing to pay, consumer surplus, and the demand curve are all closely
related. The height of the demand curve represents the willingness to pay of the buyers.
Consumer surplus is the area below the demand curve and above the price, which equals the
price that each buyer is willing to pay minus the price actually paid.
2.
Sellers' costs, producer surplus, and the supply curve are all closely related. The height of the
supply curve represents the costs of the sellers. Producer surplus is the area below the price and
above the supply curve, which equals the price received minus each seller's costs of producing
the good.
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Figure 4
3.
Figure 4 shows producer and consumer surplus in a supply-and-demand diagram.
4.
An allocation of resources is efficient if it maximizes total surplus, the sum of consumer surplus
and producer surplus. But efficiency may not be the only goal of economic policymakers; they
may also be concerned about equity⎯the fairness of the distribution of well-being.
5.
The invisible hand of the marketplace guides the self-interest of buyers and sellers into
promoting general economic well-being. Despite decentralized decision making and selfinterested decision makers, free markets lead to an efficient outcome.
6.
Two types of market failure are market power and externalities. Market power may cause market
outcomes to be inefficient because firms may cause price and quantity to differ from the levels
they would be under perfect competition, which keeps total surplus from being maximized.
Externalities are side effects that are not taken into account by buyers and sellers. As a result,
the free market does not maximize total surplus.
144 ) Chapter 7/Consumers, Producers, and the Efficiency of Markets
Problems and Applications
1.
If an early freeze in California sours the lemon crop, the supply curve for lemons shifts to the left,
as shown in Figure 5. The result is a rise in the price of lemons and a decline in consumer surplus
from A + B + C to just A. So consumer surplus declines by the amount B + C.
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Figure 5
In the market for lemonade, the higher cost of lemons reduces the supply of lemonade, as
shown in Figure 6. The result is a rise in the price of lemonade and a decline in consumer surplus
from D + E + F to just D, a loss of E + F. Note that an event that affects consumer surplus in
one market often has effects on consumer surplus in other markets.
Figure 6
Chapter 7/Consumers, Producers, and the Efficiency of Markets ) 145
2.
A rise in the demand for French bread leads to an increase in producer surplus in the market for
French bread, as shown in Figure 7. The shift of the demand curve leads to an increased price,
which increases producer surplus from area A to area A + B + C.
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Figure 7
The increased quantity of French bread being sold increases the demand for flour, as shown in
Figure 8. As a result, the price of flour rises, increasing producer surplus from area D to D + E +
F. Note that an event that affects producer surplus in one market leads to effects on producer
surplus in related markets.
Figure 8
146 ) Chapter 7/Consumers, Producers, and the Efficiency of Markets
3.
a.
Bert’s demand schedule is:
Price
More than $7
$5 to $7
$3 to $5
$1 to $3
$1 or less
Quantity Demanded
0
1
2
3
4
Bert’s demand curve is shown in Figure 9.
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Figure 9
b.
When the price of a bottle of water is $4, Bert buys two bottles of water. His consumer
surplus is shown as area A in the figure. He values his first bottle of water at $7, but
pays only $4 for it, so has consumer surplus of $3. He values his second bottle of water
at $5, but pays only $4 for it, so has consumer surplus of $1. Thus Bert’s total consumer
surplus is $3 + $1 = $4, which is the area of A in the figure.
c.
When the price of a bottle of water falls from $4 to $2, Bert buys three bottles of water,
an increase of one. His consumer surplus consists of both areas A and B in the figure, an
increase in the amount of area B. He gets consumer surplus of $5 from the first bottle
($7 value minus $2 price), $3 from the second bottle ($5 value minus $2 price), and $1
from the third bottle ($3 value minus $2 price), for a total consumer surplus of $9. Thus
consumer surplus rises by $5 (which is the size of area B) when the price of a bottle of
water falls from $4 to $2.
Chapter 7/Consumers, Producers, and the Efficiency of Markets ) 147
4.
a.
Ernie’s supply schedule for water is:
Price
More than $7
$5 to $7
$3 to $5
$1 to $3
Less than $1
Quantity Supplied
4
3
2
1
0
Ernie’s supply curve is shown in Figure 10.
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Figure 10
5.
b.
When the price of a bottle of water is $4, Ernie sells two bottles of water. His producer
surplus is shown as area A in the figure. He receives $4 for his first bottle of water, but it
costs only $1 to produce, so Ernie has producer surplus of $3. He also receives $4 for his
second bottle of water, which costs $3 to produce, so he has producer surplus of $1.
Thus Ernie’s total producer surplus is $3 + $1 = $4, which is the area of A in the figure.
c.
When the price of a bottle of water rises from $4 to $6, Ernie sells three bottles of water,
an increase of one. His producer surplus consists of both areas A and B in the figure, an
increase by the amount of area B. He gets producer surplus of $5 from the first bottle
($6 price minus $1 cost), $3 from the second bottle ($6 price minus $3 cost), and $1
from the third bottle ($6 price minus $5 price), for a total producer surplus of $9. Thus
producer surplus rises by $5 (which is the size of area B) when the price of a bottle of
water rises from $4 to $6.
a.
From Ernie’s supply schedule and Bert’s demand schedule, the quantity demanded and
supplied are:
Price
$2
$4
$6
Quantity Supplied
1
2
3
Quantity Demanded
3
2
1
148 ) Chapter 7/Consumers, Producers, and the Efficiency of Markets
Only a price of $4 brings supply and demand into equilibrium, with an equilibrium
quantity of two.
6.
b.
At a price of $4, consumer surplus is $4 and producer surplus is $4, as shown in
Problems 3 and 4 above. Total surplus is $4 + $4 = $8.
c.
If Ernie produced one less bottle, his producer surplus would decline to $3, as shown in
Problem 4 above. If Bert consumed one less bottle, his consumer surplus would decline
to $3, as shown in Problem 3 above. So total surplus would decline to $3 + $3 = $6.
d.
If Ernie produced one additional bottle of water, his cost would be $5, but the price is
only $4, so his producer surplus would decline by $1. If Bert consumed one additional
bottle of water, his value would be $3, but the price is $4, so his consumer surplus would
decline by $1. So total surplus declines by $1 + $1 = $2.
a.
The effect of falling production costs in the market for stereos results in a shift to the
right in the supply curve, as shown in Figure 11. As a result, the equilibrium price of
stereos declines and the equilibrium quantity increases.
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Figure 11
b.
The decline in the price of stereos increases consumer surplus from area A to A + B + C
+ D, an increase in the amount B + C + D. Prior to the shift in supply, producer surplus
was areas B + E (the area above the supply curve and below the price). After the shift in
supply, producer surplus is areas E + F + G. So producer surplus changes by the amount
F + G – B, which may be positive or negative. The increase in quantity increases
producer surplus, while the decline in the price reduces producer surplus. Because
consumer surplus rises by B + C + D and producer surplus rises by F + G – B, total
surplus rises by C + D + F + G.
Chapter 7/Consumers, Producers, and the Efficiency of Markets ) 149
c.
If the supply of stereos is very elastic, then the shift of the supply curve benefits
consumers most. To take the most dramatic case, suppose the supply curve were
horizontal, as shown in Figure 12. Then there is no producer surplus at all. Consumers
capture all the benefits of falling production costs, with consumer surplus rising from
area A to area A + B.
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Figure 12
Figure 13 shows supply and demand curves for haircuts. Supply equals demand at a quantity of
three haircuts and a price between $4 and $5. Firms A, C, and D should cut the hair of Ellen,
Jerry, and Phil. Oprah’s willingness to pay is too low and firm B’s costs are too high, so they do
not participate. The maximum total surplus is the area between the demand and supply curves,
which totals $11 ($8 value minus $2 cost for the first haircut, plus $7 value minus $3 cost for the
second, plus $5 value minus $4 cost for the third).
$8
Ellen
Jerry
7
6
Price of Haircuts
7.
Phil
5
4
C
3
2
B
A
Oprah
D
1
1
2
3
4
Quantity of Haircuts
Figure 13
150 ) Chapter 7/Consumers, Producers, and the Efficiency of Markets
8.
a.
The effect of falling production costs in the market for computers results in a shift to the
right in the supply curve, as shown in Figure 14. As a result, the equilibrium price of
computers declines and the equilibrium quantity increases. The decline in the price of
computers increases consumer surplus from area A to A + B + C + D, an increase in the
amount B + C + D.
PMG
Figure 14
Prior to the shift in supply, producer surplus was areas B + E (the area above the supply
curve and below the price). After the shift in supply, producer surplus is areas E + F + G.
So producer surplus changes by the amount F + G – B, which may be positive or
negative. The increase in quantity increases producer surplus, while the decline in the
price reduces producer surplus. Because consumer surplus rises by B + C + D and
producer surplus rises by F + G – B, total surplus rises by C + D + F + G.
b.
Because adding machines are substitutes for computers, the decline in the price of
computers means that people substitute computers for adding machines, shifting the
demand for adding machines to the left, as shown in Figure 15. The result is a decline in
both the equilibrium price and equilibrium quantity of adding machines. Consumer
surplus in the adding-machine market changes from area A + B to A + C, a net change
of C – B. Producer surplus changes from area C + D + E to area E, a net loss of C + D.
Adding-machine producers are sad about technological advances in computers because
their producer surplus declines.
Chapter 7/Consumers, Producers, and the Efficiency of Markets ) 151
Figure 15
c.
Because software and computers are complements, the decline in the price and increase
in the quantity of computers means that the demand for software increases, shifting the
demand for software to the right, as shown in Figure 16. The result is an increase in both
the price and quantity of software. Consumer surplus in the software market changes
from B + C to A + B, a net change of A – C. Producer surplus changes from E to C + D +
E, an increase of C + D, so software producers should be happy about the technological
progress in computers.
PMG
Figure 16
d.
Yes, this analysis helps explain why Bill Gates is one the world’s richest people, because
his company produces a lot of software that is a complement with computers and there
has been tremendous technological advance in computers.
152 ) Chapter 7/Consumers, Producers, and the Efficiency of Markets
9.
a.
Figure 17 illustrates the demand for medical care. If each procedure has a price of $100,
quantity demanded will be Q1 procedures.
Figure 17
PMG
b.
If consumers pay only $20 per procedure, the quantity demanded will be Q2 procedures.
Because the cost to society is $100, the number of procedures performed is too large to
maximize total surplus. The quantity that maximizes total surplus is Q1 procedures, which
is less than Q2.
c.
The use of medical care is excessive in the sense that consumers get procedures whose
value is less than the cost of producing them. As a result, the economy’s total surplus is
reduced.
d.
To prevent this excessive use, the consumer must bear the marginal cost of the
procedure. But this would require eliminating insurance. Another possibility would be that
the insurance company, which pays most of the marginal cost of the procedure ($80, in
this case) could decide whether the procedure should be performed. But the insurance
company does not get the benefits of the procedure, so its decisions may not reflect the
value to the consumer.
Chapter 7/Consumers, Producers, and the Efficiency of Markets ) 153
10.
a.
Figure 18 illustrates the effect of the drought. The supply curve shifts to the left, leading
to a rise in the equilibrium price from P1 to P2 and a decline in the equilibrium quantity
from Q1 to Q2.
PMG
Figure 18
b.
If the price of water is not allowed to change, there will be a shortage of water, with the
shortage shown on the figure as the difference between Q1 and Q3.
c.
The system for allocating water is inefficient because it no longer allocates water to
those who value it most highly. Some people who value water at more than its cost of
production will be unable to obtain it, so society’s total surplus is not maximized.
The allocation system seems unfair as well. Water is allocated simply on past usage,
rewarding past wastefulness. If a family’s demand for water increases, say because of an
increase in family size, the policy does not allow them to obtain more water. Poor
families, who probably used water mostly for necessary uses like drinking, would suffer
more than wealthier families who would have to cut back only on luxury uses of water
like operating backyard fountains and pools. However, the policy also keeps the price of
water lower, which benefits poor families, because more of their family budget would
have to be used to purchase water if the price was allowed to rise.
d.
If the city allowed the price of water to rise to its equilibrium price P2, the allocation
would be more efficient. Quantity supplied would equal quantity demanded and there
would be no shortage. Total surplus would be maximized.
Whether the market allocation would be more or less fair than the proportionate
reduction in water under the old policy is difficult to say, but it is likely to be fair. Notice
that the quantity supplied would be higher (Q2) in this case than under the water
restrictions (Q3), so there is less reduction in water usage. To make the market solution
even fairer, the government could provide increased tax relief or welfare payments for
poor families who suffer from paying the higher water prices.
154 ) Chapter 7/Consumers, Producers, and the Efficiency of Markets
11.
a.
The supply and demand curves are shown in Figure 19. The equilibrium price and
quantity are found by equating quantity demanded and quantity supplied:
4P – 80 = 100 – 2P
6P = 180
P = $3.00
Q = 40
The equilibrium price is $3 per bushel and the equilibrium quantity is 40 bushels.
Price of
Broccoli
50
S
30
20
D
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40
Quantity of
Broccoli
(bushels)
Figure 19
b.
At the market equilibrium, consumer surplus is equal to (0.5)($20)(40) = $400. Producer
surplus at market equilibrium is (0.5)($10)(40) = $200. Therefore, total surplus is $400
+ $200 = $600.
c.
If a dictator banned the sale of broccoli, producer and consumer surplus would both fall
to $0. Buyers would be harmed more than sellers would because the decline in consumer
surplus would be greater than the decline in producer surplus.
Chapter 8
of Taxation
8
APPLICATION: THE COSTS OF
TAXATION
WHAT’S NEW IN THE FOURTH EDITION:
There is a new In the News box that discusses how tax rates affect work effort.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
¾
how taxes reduce consumer and producer surplus.
¾
the meaning and causes of the deadweight loss from a tax.
¾
why some taxes have larger deadweight losses than others.
¾
how tax revenue and deadweight loss vary with the size of a tax.
PMG
CONTEXT AND PURPOSE:
Chapter 8 is the second chapter in a three-chapter sequence dealing with welfare economics. In the
previous section on supply and demand, Chapter 6 introduced taxes and demonstrated how a tax affects
the price and quantity sold in a market. Chapter 6 also described the factors that determine how the
burden of the tax is divided between the buyers and sellers in a market. Chapter 7 developed welfare
economics—the study of how the allocation of resources affects economic well-being. Chapter 8
combines the lessons learned in Chapters 6 and 7 and addresses the effects of taxation on welfare.
Chapter 9 will address the effects of trade restrictions on welfare.
The purpose of Chapter 8 is to apply the lessons learned about welfare economics in Chapter 7 to
the issue of taxation that was addressed in Chapter 6. Students will learn that the cost of a tax to buyers
and sellers in a market exceeds the revenue collected by the government. Students will also learn about
the factors that determine the degree by which the cost of a tax exceeds the revenue collected by the
government.
155
156 ) Chapter 8 /Application: The Costs of Taxation
KEY POINTS:
1. A tax on a good reduces the welfare of buyers and sellers of the good, and the reduction in
consumer and producer surplus usually exceeds the revenue raised by the government. The fall in
total surplus—the sum of consumer surplus, producer surplus, and tax revenue—is called the
deadweight loss of the tax.
2. Taxes have deadweight losses because they cause buyers to consume less and sellers to produce
less, and these changes in behavior shrink the size of the market below the level that maximizes total
surplus. Because the elasticities of supply and demand measure how much market participants
respond to market conditions, larger elasticities imply larger deadweight losses.
3. As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. Because a tax
reduces the size of a market, however, tax revenue does not continually increase. It first rises with
the size of a tax, but if a tax gets large enough, tax revenue starts to fall.
CHAPTER OUTLINE:
I.
The Deadweight Loss of Taxation
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A.
Remember that it does not matter who a tax is levied on; buyers and sellers will likely
share in the burden of the tax.
B.
If there is a tax on a product, the price that a buyer pays will be greater than the price
the seller receives. Thus, there is a tax wedge between the two prices and the quantity
sold will be smaller if there was no tax.
Figure 1
Chapter 8 /Application: The Costs of Taxation ) 157
C.
How a Tax Affects Market Participants
Figure 2
PMG
1.
We can measure the effects of a tax on consumers by examining the change in
consumer surplus. Similarly, we can measure the effects of the tax on producers
by looking at the change in producer surplus.
2.
However, there is a third party that is affected by the tax—the government,
which gets total tax revenue of T × Q. If the tax revenue is used to provide
goods and services to the public, then the benefit from the tax revenue must not
be ignored.
If you spent enough time covering consumer and producer surplus in Chapter 7,
students should have an easy time with this concept.
Figure 3
3.
4.
Welfare without a Tax
a.
Consumer surplus is equal to: A + B + C.
b.
Producer surplus is equal to: D + E + F.
c.
Total surplus is equal to: A + B + C + D + E + F.
Welfare with a Tax
a.
Consumer surplus is equal to: A.
158 ) Chapter 8 /Application: The Costs of Taxation
5.
6.
D.
b.
Producer surplus is equal to: F.
c.
Tax revenue is equal to: B + D.
d.
Total surplus is equal to: A + B + D + F.
Changes in Welfare
a.
Consumer surplus changes by: –(B + C).
b.
Producer surplus changes by: –(D + E).
c.
Tax revenue changes by: +(B + D).
d.
Total surplus changes by: –(C + E).
Definition of deadweight loss: the fall in total surplus that results from a
market distortion, such as a tax.
Deadweight Losses and the Gains from Trade
PMG
Figure 4
1.
Taxes cause deadweight losses because they prevent buyers and sellers from
benefiting from trade.
2.
This occurs because the quantity of output declines; trades that would be
beneficial to both the buyer and seller will not take place because of the tax.
Show the students that the nature of this deadweight loss stems from the reduction
in the quantity of the output exchanged. Stress the idea that goods that are not
produced, consumed, or taxed do not generate benefits for anyone.
3.
The deadweight loss is equal to areas C and E (the drop in total surplus).
4.
Note that output levels between the equilibrium quantity without the tax and the
quantity with the tax will not be produced, yet the value of these units to
consumers (represented by the demand curve) is larger than the cost of these
units to producers (represented by the supply curve).
Chapter 8 /Application: The Costs of Taxation ) 159
II.
The Determinants of the Deadweight Loss
Figure 5
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A.
B.
The price elasticities of supply and demand will determine the size of the deadweight loss
that occurs from a tax.
1.
Given a stable demand curve, the deadweight loss is larger when supply is
relatively elastic.
2.
Given a stable supply curve, the deadweight loss is larger when demand is
relatively elastic.
Case Study: The Deadweight Loss Debate
1.
Social Security tax and federal income tax are taxes on labor earnings. A labor
tax places a tax wedge between the wage the firm pays and the wage that
workers receive.
2.
There is considerable debate among economists concerning the size of the
deadweight loss from this wage tax.
160 ) Chapter 8 /Application: The Costs of Taxation
3.
This is because the size of the deadweight loss depends on the elasticity of labor
supply and demand, and there is disagreement about the magnitude of the
elasticity of supply.
a.
Economists who argue that labor taxes do not greatly distort market
outcomes believe that labor supply is fairly inelastic.
b.
Economists who argue that labor taxes lead to large deadweight losses
believe that labor supply is more elastic.
Activity 1—Labor Taxes
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class discussion
Deadweight loss, taxation
None
10 minutes
Works in any size class
Purpose
Most students have not spent a great deal of time considering the effects of taxation on labor
supply. This in-class exercise gives them the opportunity to consider the effects of proposed
tax rates on their own willingness to supply labor.
PMG
Instructions
Ask students to assume that they are full-time workers earning $10 per hour, $80 per day,
$400 per week, $20,000 per year.
Ask them if they would quit their jobs or keep working if the tax rate was 10%, 20%, 30%,
… (up to 100%).
Keep a tally as they show hands indicating that they are leaving the labor force.
Ask students what they think the “best” tax rate is.
Points for Discussion
Many students have no idea that current marginal tax rates are greater than 30% for many
taxpayers.
Students will likely say that a tax rate of zero would be best, but remind them that there
would be no roads, libraries, parks, or national defense without at least some revenue raised
by the government.
C.
FYI: Henry George and the Land Tax
1.
Henry George was a 19th-century economist who suggested that the government
raise all of its revenue from a tax on land.
2.
Remember that the burden of a tax falls more heavily on the side of the market
that is less elastic. Because the supply of land is fixed, the supply of land is a
Chapter 8 /Application: The Costs of Taxation ) 161
vertical line and the elasticity is equal to zero. Thus, landowners bear the entire
burden of the tax.
III.
3.
There would also be no tax wedge in this case because the supply curve is
vertical and this implies that there is no deadweight loss (because the
government’s tax revenue is exactly equal to the landowners’ losses).
4.
However, the tax would occur without a deadweight loss only if it was a tax on
raw land rather than improvements on the land.
Deadweight Loss and Tax Revenue as Taxes Vary
Figure 6
A.
As taxes increase, the deadweight loss from the tax increases.
B.
In fact, as taxes increase, the deadweight loss rises more quickly than the size of the tax.
1.
The deadweight loss is the area of a triangle and the area of a triangle depends
on the square of its size.
PMG
2.
If we double the size of a tax, the base and height of the triangle both double so
the area of the triangle (the deadweight loss) rises by a factor of four.
ALTERNATIVE CLASSROOM EXAMPLE:
Draw a graph showing the demand and supply of paper clips. (Draw each curve as a 45degree line so that buyers and sellers will share any tax equally.) Mark the equilibrium price
as $0.50 (per box) and the equilibrium quantity as 1,000 boxes. Show students the areas of
producer and consumer surplus.
Impose a $0.20 tax on each box. Assume that sellers are required to “pay” the tax to the
government. Show students that:
ƒ
ƒ
ƒ
ƒ
the price buyers pay will rise to $0.60.
the price sellers receive will fall to $0.40.
the quantity of toilet paper purchased will fall (assume to 800 units).
tax revenue would be equal to $160 ($0.20 × 800).
Have students calculate the area of deadweight loss. (You may have to remind students how
to calculate the area of a triangle.)
Show students that as the tax increases (to $0.40, $0.60, and $0.80), tax revenue rises and
then falls, and the deadweight loss increases.
C.
As the tax increases, the level of tax revenue will eventually fall.
D.
Case Study: The Laffer Curve and Supply-Side Economics
1.
The relationship between the size of a tax and the level of tax revenues is called
a Laffer curve.
162 ) Chapter 8 /Application: The Costs of Taxation
E.
2.
Supply-side economists in the 1980s used the Laffer curve to support their belief
that a drop in tax rates could lead to an increase in tax revenue for the
government.
3.
Economists continue to debate Laffer’s argument.
a.
Many believe that the 1980s refuted Laffer’s theory.
b.
Others believe that the events of the 1980s tell a more favorable supplyside story.
c.
Some economists believe that, while an overall cut in taxes normally
decreases revenue, some taxpayers may find themselves on the wrong
side of the Laffer curve.
In the News: On the Way to France
1.
Tax rates affect work effort.
2.
This is an article from the Wall Street Journal that discusses how tax rates and
hours worked varies across several countries.
PMG
Activity 2—Tax Alternatives
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
Taxes and deadweight loss
None
20 minutes
Works in any size class
Purpose
The market impact of taxes can be a new concept to many students. This exercise helps them
think about the effects of taxes on different goods. Taxes that may be appealing for equity
reasons can be distortionary from a market perspective.
Instructions
Tell the class, “The state has decided to increase funding for public education. They are
considering four alternative taxes to finance these expenditures. All four taxes would raise the
same amount of revenue.” List these options on the board:
1.
A sales tax on food.
2.
A tax on families with school-age children.
3.
A property tax on vacation homes.
4.
A sales tax on jewelry.
Ask the students to answer the following questions. Give them time to write an answer, and
then discuss their answers before moving to the next question:
A.
Taxes change incentives. How might individuals change their behavior because of
each of these taxes?
B.
Rank these taxes from smallest deadweight loss to largest deadweight loss. Explain.
C.
Is deadweight loss the only thing to consider when designing a tax system?
Chapter 8 /Application: The Costs of Taxation ) 163
Common Answers and Points for Discussion
A.
Taxes change incentives. How might individuals change their behavior because of
each of these taxes?
1. A sales tax on food: At the margin, some consumers will purchase less food.
Overall food purchases will not decrease substantially because the tax will be
spread over a large number of consumers and demand is relatively inelastic.
2. A tax on families with school-age children: No families would put their children up
for adoption to avoid taxes. A large tax could have implications for family
planning; couples may choose not to have children, or to have fewer children,
over time. A more realistic concern would be relocation to other states by mobile
families.
3. A property tax on vacation homes: This tax would be concentrated on fewer
households. A large tax would discourage people from buying vacation homes.
Developers would build fewer vacation homes in the long run. In many areas,
people could choose an out-of-state vacation home.
4. A sales tax on jewelry: This tax would also be relatively concentrated. People
would buy less jewelry, or they would buy jewelry in other states with lower
taxes.
B.
C.
PMG
Rank these taxes from smallest deadweight loss to largest deadweight loss.
Lowest deadweight loss—tax on children, very inelastic.
Then—tax on food. Demand is inelastic; supply is elastic.
Third—tax on vacation homes. Demand is elastic; short-run supply is inelastic.
Most deadweight loss—tax on jewelry. Demand is elastic; supply is elastic.
Is deadweight loss the only thing to consider when designing a tax system?
No. This can generate a lively discussion. There are a variety of equity or fairness
concerns. The taxes on children and on food would be regressive. Each of the taxes
would tax certain households at much higher rates than other households with similar
incomes.
164 ) Chapter 8 /Application: The Costs of Taxation
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can be found near the end of the textbook.
1.
Figure 1 shows the supply and demand curves for cookies, with equilibrium quantity Q1 and
equilibrium price P1. When the government imposes a tax on cookies, the price to buyers rises to
PB, the price received by sellers declines to PS, and the equilibrium quantity falls to Q2. The
deadweight loss is the triangular area below the demand curve and above the supply curve
between quantities Q1 and Q2. The deadweight loss shows the fall in total surplus that results
from the tax.
PMG
Figure 1
2.
The deadweight loss of a tax is greater the greater is the elasticity of demand. Therefore, a tax
on beer would have a larger deadweight loss than a tax on milk because the demand for beer is
more elastic than the demand for milk.
3.
If the government doubles the tax on gasoline, the revenue from the gasoline tax could rise or
fall depending on whether the size of the tax is on the upward or downward sloping portion of
the Laffer curve. However, if the government doubles the tax on gasoline, you can be sure that
the deadweight loss of the tax rises because deadweight loss always rises as the tax rate rises.
Questions for Review
1.
When the sale of a good is taxed, both consumer surplus and producer surplus decline. The
decline in consumer surplus and producer surplus exceeds the amount of government revenue
that is raised, so society's total surplus declines. The tax distorts the incentives of both buyers
and sellers, so resources are allocated inefficiently.
Chapter 8 /Application: The Costs of Taxation ) 165
2.
Figure 2 illustrates the deadweight loss and tax revenue from a tax on the sale of a good.
Without a tax, the equilibrium quantity would be Q1, the equilibrium price would be P1, consumer
surplus would be A + B + C, and producer surplus would be D + E + F. The imposition of a tax
places a wedge between the price buyers pay, PB, and the price sellers receive, PS, where PB = PS
+ tax. The quantity sold declines to Q2. Now consumer surplus is A, producer surplus is F, and
government revenue is B + D. The deadweight loss of the tax is C+E, because that area is lost
due to the decline in quantity from Q1 to Q2.
PMG
Figure 2
3.
4.
5.
The greater the elasticities of demand and supply, the greater the deadweight loss of a tax.
Because elasticity measures the response of quantity to a change in price, higher elasticity means
the tax induces a greater reduction in quantity, and therefore, a greater distortion to the market.
Experts disagree about whether labor taxes have small or large deadweight losses because they
have different views about the elasticity of labor supply. Some believe that labor supply is
inelastic, so a tax on labor has a small deadweight loss. But others think that workers can adjust
their hours worked in various ways, so labor supply is elastic, and thus a tax on labor has a large
deadweight loss.
The deadweight loss of a tax rises more than proportionally as the tax rises. Tax revenue,
however, may increase initially as a tax rises, but as the tax rises further, revenue eventually
declines.
166 ) Chapter 8 /Application: The Costs of Taxation
Problems and Applications
1.
a.
Figure 3 illustrates the market for pizza. The equilibrium price is P1, the equilibrium
quantity is Q1, consumer surplus is area A + B + C, and producer surplus is area D + E +
F. There is no deadweight loss, as all the potential gains from trade are realized; total
surplus is the entire area between the demand and supply curves: A + B + C + D + E +
F.
PMG
Figure 3
2.
b.
With a $1 tax on each pizza sold, the price paid by buyers, PB, is now higher than the
price received by sellers, PS, where PB = PS + $1. The quantity declines to Q2, consumer
surplus is area A, producer surplus is area F, government revenue is area B + D, and
deadweight loss is area C + E. Consumer surplus declines by B + C, producer surplus
declines by D + E, government revenue increases by B + D, and deadweight loss
increases by C + E.
c.
If the tax were removed and consumers and producers voluntarily transferred B + D to
the government to make up for the lost tax revenue, then everyone would be better off
than without the tax. The equilibrium quantity would be Q1, as in the case without the
tax, and the equilibrium price would be P1. Consumer surplus would be A + C, because
consumers get surplus of A + B + C, then voluntarily transfer B to the government.
Producer surplus would be E + F, because producers get surplus of D + E + F, then
voluntarily transfer D to the government. Both consumers and producers are better off
than the case when the tax was imposed. If consumers and producers gave a little bit
more than B + D to the government, then all three parties, including the government,
would be better off. This illustrates the inefficiency of taxation.
a.
The statement, "If the government taxes land, wealthy landowners will pass the tax on
to their poorer renters," is incorrect. With a tax on land, landowners cannot pass the tax
on. Because the supply curve of land is perfectly inelastic, landowners bear the entire
burden of the tax. Renters will not be affected at all.
Chapter 8 /Application: The Costs of Taxation ) 167
3.
4.
b.
The statement, "If the government taxes apartment buildings, wealthy landowners will
pass the tax on to their poorer renters," is partially correct. With a tax on apartment
buildings, landowners can pass the tax on more easily, though the extent to which they
do this depends on the elasticities of supply and demand. In this case, the tax is a direct
addition to the cost of rental units, so the supply curve will shift up by the amount of the
tax. The tax will be shared by renters and landowners, depending on the elasticities of
demand and supply.
a.
The statement, "A tax that has no deadweight loss cannot raise any revenue for the
government," is incorrect. An example is the case of a tax when either supply or demand
is perfectly inelastic. The tax has neither an effect on quantity nor any deadweight loss,
but it does raise revenue.
b.
The statement, "A tax that raises no revenue for the government cannot have any
deadweight loss," is incorrect. An example is the case of a 100% tax imposed on sellers.
With a 100% tax on their sales of the good, sellers will not supply any of the good, so
the tax will raise no revenue. Yet the tax has a large deadweight loss, because it reduces
the quantity sold to zero.
a.
With very elastic supply and very inelastic demand, the burden of the tax on rubber
bands will be borne largely by buyers. As Figure 4 shows, consumer surplus declines
considerably, by area A + B, but producer surplus does not fall much at all, just by area
C + D.
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Figure 4
168 ) Chapter 8 /Application: The Costs of Taxation
b.
With very inelastic supply and very elastic demand, the burden of the tax on rubber
bands will be borne largely by sellers. As Figure 5 shows, consumer surplus does not
decline much, just by area A + B, while producer surplus falls substantially, by area C +
D. Compared to part (a), producers bear much more of the burden of the tax, and
consumers bear much less.
PMG
Figure 5
5.
a.
The deadweight loss from a tax on heating oil is likely to be greater in the fifth year after
it is imposed rather than the first year. In the first year, the elasticity of demand is fairly
low, as people who own oil heaters are not likely to get rid of them right away. But over
time they may switch to other energy sources and people buying new heaters for their
homes will more likely choose gas or electric, so the tax will have a greater impact on
quantity. Thus, the deadweight loss of the tax will get larger over time.
b.
The tax revenue is likely to be higher in the first year after it is imposed than in the fifth
year. In the first year, demand is more inelastic, so the quantity does not decline as
much and tax revenue is relatively high. As time passes and more people substitute away
from oil, the quantity sold declines, as does tax revenue.
6.
Because the demand for food is inelastic, a tax on food is a good way to raise revenue because it
does not lead to much of a deadweight loss; thus taxing food is less inefficient than taxing other
things. But it is not a good way to raise revenue from an equity point of view, because poorer
people spend a higher proportion of their income on food. The tax would hit them harder than it
would hit wealthier people.
7.
a.
This tax has such a high rate that it is not likely to raise much revenue. Because of the
high tax rate, the equilibrium quantity in the market is likely to be at or near zero.
b.
Senator Moynihan's goal was probably to ban the use of hollow-tipped bullets. In this
case, the tax could be as effective as an outright ban.
a.
Figure 6 illustrates the market for socks and the effects of the tax. Without a tax, the
equilibrium quantity would be Q1, the equilibrium price would be P1, total spending by
consumers equals total revenue for producers, which is P1 x Q1, which equals area B + C
+ D + E + F, and government revenue is zero. The imposition of a tax places a wedge
8.
Chapter 8 /Application: The Costs of Taxation ) 169
between the price buyers pay, PB, and the price sellers receive, PS, where PB = PS + tax.
The quantity sold declines to Q2. Now total spending by consumers is PB x Q2, which
equals area A + B + C + D, total revenue for producers is PS x Q2, which is area C + D,
and government tax revenue is Q2 x tax, which is area A + B.
b.
Unless supply is perfectly elastic or demand is perfectly inelastic, the price received by
producers falls because of the tax. Total receipts for producers fall, because producers
lose revenue equal to area B + E + F.
PMG
Figure 6
c.
9.
The price paid by consumers rises, unless demand is perfectly elastic or supply is
perfectly inelastic. Whether total spending by consumers rises or falls depends on the
price elasticity of demand. If demand is elastic, the percentage decline in quantity
exceeds the percentage increase in price, so total spending declines. If demand is
inelastic, the percentage decline in quantity is less than the percentage increase in price,
so total spending rises. Whether total consumer spending falls or rises, consumer surplus
declines because of the increase in price and reduction in quantity.
Because the tax on gadgets was eliminated, all tax revenue must come from the tax on widgets.
The tax revenue from the tax on widgets equals the tax per unit times the quantity produced.
Assuming that neither the supply nor the demand curves for widgets are perfectly elastic or
inelastic and because the increased tax causes a smaller quantity of widgets to be produced,
then it is impossible for tax revenue to double—multiplying the tax per unit (which doubles) times
the quantity (which declines) gives a number that is less than double the original tax revenue
from widgets. So the government's tax change will yield less money than before.
170 ) Chapter 8 /Application: The Costs of Taxation
10.
Figure 7 illustrates the effects of the $2 subsidy on a good. Without the subsidy, the equilibrium
price is P1 and the equilibrium quantity is Q1. With the subsidy, buyers pay price PB, producers
receive price PS (where PS = PB + $2), and the quantity sold is Q2. The following table illustrates
the effect of the subsidy on consumer surplus, producer surplus, government revenue, and total
surplus. Because total surplus declines by area D + H, the subsidy leads to a deadweight loss in
that amount.
OLD
Consumer
Surplus
Producer
Surplus
Government
Revenue
Total Surplus
NEW
CHANGE
A+B
A+B+E+F+G
+(E + F + G)
E+I
B+C+E+I
+(B + C)
0
A+B+E+I
–(B + C + D + E + F + G + H)
A+B–D+E–H+I
–(B + C + D + E + F + G + H)
–(D + H)
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Figure 7
Chapter 8 /Application: The Costs of Taxation ) 171
11.
a.
Figure 8 shows the effect of a $10 tax on hotel rooms. The tax revenue is represented by
areas A + B, which are equal to ($10)(900) = $9,000. The deadweight loss from the tax
is represented by areas C + D, which are equal to (0.5)($10)(100) = $500.
Price of
Hotel Room
S
108
100
98
A
C
B
D
D
900 1,000
Quantity of
Hotel Rooms
Figure 8
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b.
Figure 9 shows the effect of a $20 tax on hotel rooms. The tax revenue is represented by
areas A + B, which are equal to ($20)(800) = $16,000. The deadweight loss from the tax
is represented by areas C + D, which are equal to (0.5)($20)(200) = $2,000.
Price of
Hotel Rooms
116
S
A
100
B
C
D
96
D
800
1,000
Quantity of
Hotel Rooms
Figure 9
When the tax is doubled, the tax revenue rises by less than double, while the deadweight
loss rises by more than double.
12.
a.
Setting quantity supplied equal to quantity demanded gives 2P = 300 – P. Adding P to
both sides of the equation gives 3P = 300. Dividing both sides by 3 gives P = 100.
Plugging P = 100 back into either equation for quantity demanded or supplied gives Q =
200.
172 ) Chapter 8 /Application: The Costs of Taxation
b.
Now P is the price received by sellers and P +T is the price paid by buyers. Equating
quantity demanded to quantity supplied gives 2P = 300 - (P+T). Adding P to both sides
of the equation gives 3P = 300 – T. Dividing both sides by 3 gives P = 100 –T/3. This is
the price received by sellers. The buyers pay a price equal to the price received by sellers
plus the tax (P +T = 100 + 2T/3). The quantity sold is now Q = 2P = 200 – 2T/3.
c.
Because tax revenue is equal to T x Q and Q = 200 – 2T/3, tax revenue equals
200T - 2T 2 /3. Figure 10 shows a graph of this relationship. Tax revenue is zero at T = 0
and at T = 300.
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Figure 10
d.
As Figure 11 shows, the area of the triangle (laid on its side) that represents the
deadweight loss is 1/2 x base x height, where the base is the change in the price, which
is the size of the tax (T) and the height is the amount of the decline in quantity (2T/3).
So the deadweight loss equals 1/2 x T x 2T/3 = T 2 /3. This rises exponentially from 0
(when T = 0) to 45,000 when T = 300, as shown in Figure 12.
Figure 11
Chapter 8 /Application: The Costs of Taxation ) 173
Figure 12
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e.
A tax of $200 per unit is a bad idea, because it is in a region in which tax revenue is
declining. The government could reduce the tax to $150 per unit, get more tax revenue
($15,000 when the tax is $150 versus $13,333 when the tax is $200), and reduce the
deadweight loss (7,500 when the tax is $150 compared to 13,333 when the tax is $200).
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9
APPLICATION: INTERNATIONAL
TRADE
WHAT’S NEW IN THE FOURTH EDITION:
There is a new FYI box on import quotas, which replaces the text discussion of this complicated subject.
There are also two new In the News boxes on “Cheap Clothes from China” and “Offshore Outsourcing.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
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¾
what determines whether a country imports or exports a good.
¾
who wins and who loses from international trade.
¾
that the gains to winners from international trade exceed the losses to losers.
¾
the welfare effects of tariffs and import quotas.
¾
the arguments people use to advocate trade restrictions.
CONTEXT AND PURPOSE:
Chapter 9 is third in a three-chapter sequence dealing with welfare economics. Chapter 7 introduced
welfare economics: the study of how the allocation of resources affects economic well-being. Chapter 8
applied the lessons of welfare economics to taxation. Chapter 9 applies the tools of welfare economics
from Chapter 7 to the study of international trade, a topic that was first introduced in Chapter 3.
The purpose of Chapter 9 is to use welfare economics to address the gains from trade more
precisely than in Chapter 3, which discussed comparative advantage and the gains from trade. This
chapter develops the conditions that determine whether a country imports or exports a good and
discusses who wins and who loses when a country imports or exports a good. This chapter will show that
when free trade is allowed, the gains of the winners exceed the losses of the losers. Because there are
gains from trade, restrictions on free trade reduce the gains from trade and cause deadweight losses
similar to those generated by a tax.
175
176 ) Chapter 9/Application: International Trade
KEY POINTS:
1. The effects of free trade can be determined by comparing the domestic price without trade to the
world price. A low domestic price indicates that the country has a comparative advantage in
producing the good and that the country will become an exporter. A high domestic price indicates
that the rest of the world has a comparative advantage in producing the good and that the country
will become an importer.
2. When a country allows trade and becomes an exporter of a good, producers of the good are better
off, and consumers of the good are worse off. When a country allows trade and becomes an importer
of a good, consumers are better off, and producers are worse off. In both cases, the gains from trade
exceed the losses.
3. A tariff—a tax on imports—moves a market closer to the equilibrium that would exist without trade
and, therefore, reduces the gains from trade. Although domestic producers are better off and the
government raises revenue, the losses to consumers exceed these gains.
4.
There are various arguments for restricting trade: protecting jobs, defending national security,
helping infant industries, preventing unfair competition, and responding to foreign trade restrictions.
Although some of these arguments have some merit in some cases, economists believe that free
trade is usually the better policy.
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CHAPTER OUTLINE:
This chapter may be difficult to teach and very difficult for students to understand
and accept. Be prepared for a skeptical reaction from students who have been told
that free international trade is detrimental to a country. For various historical,
cultural, and political reasons, free trade has few defenders outside of the economics
profession.
Point out that international trade issues are no different from trading as it applies to
individuals within a community or between states and regions within a country. The
gains from trade between countries occur for the same reasons that we observe
gains from trade between individuals.
Pick a state adjacent to yours. Ask students why we do not seem to worry about
“importing” goods from other states the same way we do about importing goods
from other countries.
I.
The Determinants of Trade
A.
Example used throughout the chapter: The market for steel in a country called Isoland.
B.
The Equilibrium without Trade
Figure 1
Chapter 9/Application: International Trade ) 177
1.
If there is no trade, the domestic price in the steel market will balance supply
and demand.
2.
A new leader is elected who is interested in pursuing trade. A committee of
economists is organized to determine the following:
a.
If the government allows trade, what will happen to the price of steel
and the quantity of steel sold in the domestic market?
b.
Who will gain from trade, who will lose, and will the gains exceed the
losses?
c.
Should some sort of import restriction be put in place in the market for
steel?
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C.
The World Price and Comparative Advantage
1.
2.
The first issue is to decide whether Isoland should import or export steel.
a.
The answer depends on the relative price of steel in Isoland compared
with the price of steel in other countries.
b.
Definition of world price: the price of a good that prevails in the
world market for that good.
If the world price is greater than the domestic price, Isoland should export steel;
if the world price is lower than the domestic price, Isoland should import steel.
a.
Note that the domestic price represents the opportunity cost of
producing steel in Isoland, while the world price represents the
opportunity cost of producing steel abroad.
b.
Thus, if the domestic price is low, this implies that the opportunity cost
of producing steel in Isoland is low, suggesting that Isoland has a
178 ) Chapter 9/Application: International Trade
comparative advantage in the production of steel. If the domestic price is
high, the opposite is true.
II.
The Winners and Losers from Trade
A.
We can use welfare analysis to determine who will gain and who will lose if free trade
begins in Isoland.
B.
We will assume that, because Isoland would be such a small part of the market for steel,
they will be price takers in the world economy. This implies that they take the world price
as given and must sell (or buy) at that price.
C.
The Gains and Losses of an Exporting Country
Figure 2
1.
If the world price is higher than the domestic price, Isoland will export steel.
Once free trade begins, the domestic price will rise to the world price.
2.
As the price of steel rises, the domestic quantity of steel demanded will fall and
the domestic quantity of steel supplied will rise. Thus, with trade, the domestic
quantity demanded will not be equal to the domestic quantity supplied.
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Have students come to the board and label the areas of consumer and producer
surplus after you have drawn each of the figures. This should not be a problem as
they are likely familiar enough with consumer and producer surplus after completing
Chapters 7 and 8.
Chapter 9/Application: International Trade ) 179
3.
Welfare without Trade
a.
Consumer surplus is equal to: A + B.
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4.
5.
D.
b.
Producer surplus is equal to: C.
c.
Total surplus is equal to: A + B + C.
Welfare with Trade
a.
Consumer surplus is equal to: A.
b.
Producer Surplus is equal to: B + C + D.
c.
Total surplus is equal to: A + B + C + D.
Changes in Welfare
a.
Consumer surplus changes by: –B.
b.
Producer surplus changes by: +(B + D).
c.
Total surplus changes by: +D.
6.
When a country exports a good, domestic producers of the good are better off
and domestic consumers of the good are worse off.
7.
When a country exports a good, total surplus is increased and the economic wellbeing of the country rises.
The Gains and Losses of an Importing Country
Figure 3
180 ) Chapter 9/Application: International Trade
1.
If the world price is lower than the domestic price, Isoland will import steel.
Once free trade begins, the domestic price will fall to the world price.
2.
As the price of steel falls, the domestic quantity of steel demanded will rise and
the domestic quantity of steel supplied will fall.
a.
Thus, with trade, the domestic quantity demanded will not be equal to
the domestic quantity supplied.
b.
Isoland will import the difference between the domestic quantity
demanded and the domestic quantity supplied.
Note that there will be both imported and domestically produced steel sold in this
country. This is true for many imported goods.
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Chapter 9/Application: International Trade ) 181
3.
4.
5.
Welfare without Trade
a.
Consumer surplus is equal to: A.
b.
Producer surplus is equal to: B + C.
c.
Total surplus is equal to: A + B + C.
Welfare with Trade
a.
Consumer surplus is equal to: A + B + D.
b.
Producer surplus is equal to: C.
c.
Total surplus is equal to: A + B + C + D.
Changes in Welfare
a.
Consumer surplus changes by: +(B + D).
b.
Producer surplus changes by: –B.
c.
Total surplus changes by: +D.
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6.
When a country imports a good, domestic consumers of the good are better off
and domestic producers of the good are worse off.
7.
When a country imports a good, total surplus is increased and the economic
well-being of the country rises.
Be prepared for students to argue that trade cannot be good for everyone. More than
likely at least one of your students will know an individual who lost his or her job
when a factory closed and moved to another country. Take this opportunity to point
out that this individual is one of the “losers,” but remind the class that the gains from
trade exceed the losses, so the total well-being of society is increased.
Point out that during the 1990s with open trading (for example, the passage of
NAFTA), the U.S. economy has achieved and maintained full employment even as
large quantities of imported goods have entered the United States. Most of the jobs
that have “left the country” have been low-skill, low-wage jobs.
E.
Trade policy is often contentious because the policy creates winners and losers. If the
losers have political clout, the result is often trade restrictions such as tariffs and quotas.
F.
In the News: Cheap Clothes from China
1.
At the end of 2004, the United States greatly expanded its openness to textile
imports from China.
2.
This is an article from The New York Times that describes the flood of clothing
that arrived in the United States as a result of this new policy.
182 ) Chapter 9/Application: International Trade
G.
The Effects of a Tariff
Figure 4
1.
Definition of tariff: a tax on goods produced abroad and sold
domestically.
2.
A tariff raises the price above the world price. Thus, the domestic price of steel
will rise to the world price plus the tariff.
3.
As the domestic price rises, the domestic quantity of steel demanded will fall and
the domestic quantity of steel supplied will rise. The quantity of imports will fall
and the market will move closer to the domestic market equilibrium that
occurred before trade.
4.
Welfare before the Tariff (with trade)
a.
Consumer surplus is equal to: A + B + C + D + E + F.
b.
Producer surplus is equal to: G.
c.
Government revenue is equal to: zero.
d.
Total surplus is equal to: A + B + C + D + E + F + G.
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5.
Welfare after the Tariff
a.
Consumer surplus is equal to: A + B.
b.
Producer surplus is equal to: C + G.
c.
Government revenue is equal to: E.
Chapter 9/Application: International Trade ) 183
d.
6.
H.
Total surplus is equal to: A + B + C + E + G.
Changes in Welfare
a.
Consumer surplus changes by: –(C + D + E + F).
b.
Producer surplus changes by: +C.
c.
Government revenue changes by: +E.
d.
Total surplus changes by: –(D + F).
FYI: Import Quotas: Another Way to Restrict Trade
1.
An import quota is a limit on the quantity of a good that can be produced abroad
and sold domestically.
2.
Import quotas are much like tariffs.
a.
Both tariffs and quotas raise the domestic price of the good, reduce the
welfare of domestic consumers, increase the welfare of domestic
producers, and cause deadweight losses.
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I.
b.
However, a tariff raises revenue for the government, whereas a quota
creates surplus for license holders.
c.
A quota can potentially cause a larger deadweight loss than a tariff,
depending on the mechanism used to allocate the import licenses.
The Lessons for Trade Policy
This section provides a good opportunity to review what the students have learned
thus far about trade. You should reinforce the idea that total surplus rises when trade
is introduced, but falls once trade restrictions are imposed.
J.
1.
If trade is allowed, the price of steel will be driven to the world price. If the
domestic price is higher than the world price, the country will become an
importer and the domestic price will fall. If the domestic price is lower than the
world price, the country will become an exporter and the domestic price will rise.
2.
If a country imports a product, domestic producers are made worse off, domestic
consumers are made better off, and the gains of consumers outweigh the losses
of producers. If a country exports a product, domestic producers are made
better off, domestic consumers are made worse off, and the gains of producers
outweigh the losses of consumers.
3.
A tariff would create a deadweight loss because total surplus would fall.
FYI: Other Benefits of International Trade
1.
In addition to increasing total surplus, there are several other benefits of free
trade.
184 ) Chapter 9/Application: International Trade
2.
III.
These include an increased variety of goods, lower costs through economies of
scale, increased competition, and an enhanced flow of ideas.
The Arguments for Restricting Trade
A.
The Jobs Argument
1.
If a country imports a product, domestic producers of the product will have to lay
off workers because they will decrease domestic output when the price declines
to the world price.
2.
Free trade, however, will create job opportunities in other industries where the
country enjoys a comparative advantage.
3.
In the News: Offshore Outsourcing
a.
In 2004, the Chairman of the Council of Economic Advisers N. Gregory
Mankiw was asked about the movement of some jobs (such as computer
tech support) overseas. He responded that the trend was “probably a
plus for the economy in the long run.”
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b.
B.
C.
D.
This is a column by George Will that discusses the fervor surrounding
Mankiw’s remarks.
The National-Security Argument
1.
Certain industries may produce key resources needed to produce products
necessary for national security.
2.
In many of the cases for which this argument is used, the role of the particular
market in providing national security is exaggerated.
The Infant-Industry Argument
1.
New industries need time to establish themselves to be able to compete in world
markets.
2.
Sometimes older industries argue that they need temporary protection to help
them adjust to new conditions.
3.
Even if this argument is legitimate, it is nearly impossible for the government to
choose which industries will be profitable in the future and it is even more
difficult to remove trade restrictions in an industry once they are in place.
The Unfair-Competition Argument
1.
It is unfair if firms in one country are forced to comply with more regulations
than firms in another country, or if another government subsidizes the
production of a good.
2.
Even if another country is subsidizing the production of a product so that it can
be exported to a country at a lower price, the domestic consumers who import
the product gain more than the domestic producers lose.
Chapter 9/Application: International Trade ) 185
E.
The Protection-as-a-Bargaining-Chip Argument
1.
Threats of protectionism can make other countries more willing to reduce the
amounts of protectionism they use.
2.
If the threat does not work, the country has to decide if it would rather reduce
the economic well-being of its citizens (by carrying out the threat) or lose
credibility in negotiations (by reneging on its threat).
Activity 1 – Free Trade or Protection?
Type :
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
Effects of protectionism, free trade
None
60 minutes
Works in any size class
Purpose
This assignment leads the students through several trade issues. Many students, including
those who can make an economic argument for free trade, have an emotional attachment to
protectionism. This exercise examines the rationale for protecting jobs and looks at the direct
and indirect costs.
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Instructions
Ask the class to answer the following questions. Give them time to write an answer to a
question, then discuss their answers before moving to the next question.
Question 4 is the hardest for students to answer; some additional explanation can help. If
consumers pay a total of $100,000 extra to save 100 U.S. jobs, then the cost of saving a job
is $1000.
1.
2.
3.
4.
Which do you favor, free trade or protection? Explain why.
Assume you are voting on a request before the U.S. International Trade Commission
to raise the tariff on imports of rubber thread. Rubber thread is made from latex and
is a relatively small industry. It is used to manufacture elastic which is used in items
like socks, underwear, and bungee cords. Increasing the tariff would allow the U.S.
producers to avoid layoffs and to invest in technology. Would you vote for the tariff
increase?
What are the benefits of keeping a job in the United States?
The costs of protectionism are paid by consumers in the form of higher prices. In
your opinion, how much extra should consumers pay to keep a job in the United
States? (Express this figure in dollars/per job.)
Common Answers and Points for Discussion
1.
Which do you favor, free trade or protection? Explain why.
Many classes will split about evenly on this question. Many points can be
presented but the argument usually comes down to economic efficiency versus jobs.
2.
Assume you are voting on a request before the U.S. International Trade Commission
to raise the tariff on imports of rubber thread. Rubber thread is made from latex and
is a relatively small industry. It is used to manufacture elastic, which is used in items
186 ) Chapter 9/Application: International Trade
like socks, underwear, and bungee cords. Increasing the tariff would allow the U.S.
producers to avoid layoffs and to invest in technology. Would you vote for the tariff
increase?
Many students, including those who generally favor free trade, will vote to
increase the tariff in this particular case.
3.
What are the benefits of keeping a job in the United States?
Workers pay taxes and purchase goods from other companies. The costs of
government payments to unemployed workers are avoided. Companies earn higher
profits. Communities are healthier.
4.
The costs of protectionism are paid by consumers in the form of higher prices. In
your opinion, how much extra should consumers pay to keep a job in the United
States? (Express this figure in dollars/per job.)
A complete free trader would say “Zero. It’s worth nothing to protect a job in
my country.” A few students will take this stand. Most students will choose a dollar
figure from $100 to $10,000. A few may go somewhat higher.
These figures are dwarfed by the actual costs of saving American jobs through trade barriers.
Estimates range from $60,000 per worker (in the bicycle industry) to $750,000 per worker (in
the steel industry.)
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This is far above the actual earning of these workers. It would be cheaper to pay them a
lump sum to retire. Subsidizing workers through trade laws is a very inefficient method of
helping them. The benefits that students list in Question 3 are real, but very small compared
to the costs.
Returning to Question 2, do we really save American jobs by increasing tariffs? Increasing the
price of inputs hurts the competitiveness of U.S. businesses. In the rubber thread case, ten
times as many U.S. workers are employed in industries that use rubber thread as an input.
Voting to protect workers in the rubber thread industry puts workers in the sock, underwear,
and bungee cord industries at risk.
More generally, increases in U.S. trade barriers cause other countries to retaliate. This puts
workers in our export industries at risk. Our most efficient industries are hurt by efforts to
protect our least efficient industries.
F.
Case Study: Trade Agreements and the World Trade Organization
1.
Countries wanting to achieve freer trade can take two approaches to cutting
trade restrictions: a unilateral approach or a multilateral approach.
2.
A unilateral approach occurs when a country lowers its trade restrictions on its
own. A multilateral approach occurs when a country reduces its trade restrictions
while other countries do the same.
3.
The North America Free Trade Agreement (NAFTA) and the General Agreement
on Tariffs and Trade (GATT) are multilateral approaches to reducing trade
barriers.
Chapter 9/Application: International Trade ) 187
G.
4.
The rules established under GATT are now enforced by the World Trade
Organization (WTO).
5.
The functions of the WTO are to administer trade agreements, provide a forum
for negotiation, and handle disputes that arise among member countries.
In the News: Globalization
1.
In recent years, there has been a vocal outcry against globalization among many
groups.
2.
This is an article written by economist Paul Krugman for The New York Times
arguing that these groups are misinformed.
Make sure that you point out the conclusion in this chapter. The chapter ends with a
very effective parable about the discovery of comparative advantage, its adoption, its
beneficial consequences, and finally, its abandonment for political reasons.
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188 ) Chapter 9/Application: International Trade
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can be found near the end of the textbook.
1.
Since wool suits are cheaper in neighboring countries, Autarka would import suits if it were to
allow free trade.
2.
Figure 1 shows the supply and demand for wool suits in Autarka. With no trade, the price of
suits is 3 ounces of gold, consumer surplus is area A, producer surplus is area B + C, and total
surplus is area A + B + C. When trade is allowed, the price falls to 2 ounces of gold, consumer
surplus rises to A + B + D (an increase of B + D), producer surplus falls to C (a decline of B), so
total surplus rises to A + B + C + D (an increase of D). A tariff on suit imports would reduce the
increase in consumer surplus, reduce the decline in producer surplus, and reduce the gain in total
surplus.
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Figure 1
3.
Lobbyists for the textile industry might make five arguments in favor of a ban on the import of
wool suits: (1) imports of wool suits destroy domestic jobs; (2) the wool-suit industry is vital for
national security; (3) the wool-suit industry is just starting up and needs protection from foreign
competition until it gets stronger; (4) other countries are unfairly subsidizing their wool-suit
industries; and (5) the ban on the importation of wool suits can be used as a bargaining chip in
international negotiations.
In defending free trade in wool suits, you could argue that: (1) free trade creates jobs in some
industries even as it destroys jobs in the wool-suit industry and allows Autarka to enjoy a higher
standard of living; (2) the role of wool suits for the military may be exaggerated; (3) government
protection is not needed for an industry to grow on its own; (4) it would be good for the citizens
of Autarka to be able to buy wool suits at a subsidized price; and (5) threats against free trade
may backfire, leading to lower levels of trade and lower economic welfare for everyone.
Chapter 9/Application: International Trade ) 189
Questions for Review
1.
If the domestic price that prevails without international trade is above the world price, the
country does not have a comparative advantage in producing the good. If the domestic price is
below the world price, the country has a comparative advantage in producing the good.
2.
A country will export a good for which its domestic price is lower than the prevailing world price.
Thus, if a country has a comparative advantage in producing a good, it will become an exporter
when trade is allowed. A country will import a product for which its domestic price is greater than
the prevailing world price. Thus, if a country does not have a comparative advantage in
producing a good, it will become an importer when trade is allowed.
3.
Figure 2 illustrates supply and demand for an importing country. Before trade is allowed,
consumer surplus is area A and producer surplus is area B + C. After trade is allowed, consumer
surplus is area A + B + D and producer surplus is area C. The change in total surplus is an
increase of area D.
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Figure 2
4.
A tariff is a tax on goods produced abroad and sold domestically. If a country is an importer of a
good, a tariff reduces the quantity of imports and moves the domestic market closer to its
equilibrium without trade, increasing the price of the good, reducing consumer surplus and total
surplus, while raising producer surplus and government revenue.
5.
The arguments given to support trade restrictions are: (1) trade destroys jobs; (2) industries
threatened with competition may be vital for national security; (3) new industries need trade
restrictions to help them get started; (4) some countries unfairly subsidize their firms, so
competition is not fair; and (5) trade restrictions can be useful bargaining chips. Economists
disagree with these arguments: (1) trade may destroy some jobs, but it creates other jobs; (2)
arguments about national security tend to be exaggerated; (3) the government cannot easily
identify new industries that are worth protecting; (4) if countries subsidize their exports, doing so
simply benefits consumers in importing countries; and (5) bargaining over trade is a risky
business, because it may backfire, making the country worse off without trade.
6.
A unilateral approach to achieving free trade occurs when a country removes trade restrictions on
its own. Under a multilateral approach, a country reduces its trade restrictions while other
countries do the same, based on an agreement reached through bargaining. The unilateral
190 ) Chapter 9/Application: International Trade
approach was taken by Great Britain in the 1800s and by Chile and South Korea in recent years.
Examples of the multilateral approach include NAFTA in 1993 and the GATT negotiations since
World War II.
Problems and Applications
1.
a.
In Figure 3, with no international trade the equilibrium price is P1 and the equilibrium
quantity is Q1. Consumer surplus is area A and producer surplus is area B + C, so total
surplus is A + B + C.
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Figure 3
2.
b.
When the Mexican orange market is opened to trade, the new equilibrium price is PW, the
quantity consumed is QD, the quantity produced domestically is QS, and the quantity
imported is QD – QS. Consumer surplus increases from A to A + B + D + E. Producer
surplus decreases from B + C to C. Total surplus changes from A + B + C to A + B + C
+ D + E, an increase of D + E.
a.
Figure 4 illustrates the Canadian market for wine, where the world price of wine is P1.
The following table illustrates the results under the heading "P1."
P1
Consumer Surplus
Producer Surplus
Total Surplus
b.
A+B+D+E
C
A+B+C+D+E
P2
A+D
B+C
A+B+C+D
CHANGE
–(B + E)
+B
–E
The shift in the Gulf Stream destroys some of the grape harvest in Europe and raises the
world price of wine to P2. The table shows the new areas of consumer, producer, and
total surplus, as well as the changes in these surplus measures. Consumers lose,
producers win, and Canada as a whole is worse off.
Chapter 9/Application: International Trade ) 191
Figure 4
3. The impact of a tariff on imported autos is shown in Figure 6. Without the tariff, the price of an
auto is PW, the quantity produced in the United States is Q1S, and the quantity purchased in the
United States is Q1D. The United States imports Q1D – Q1S autos. The imposition of the tariff raises
the price of autos to PW + t, causing an increase in quantity supplied by U.S. producers to Q2S
and a decline in the quantity demanded to Q2D. This reduces the number of imports to Q2D – Q2S.
The table shows the areas of consumer surplus, producer surplus, government revenue, and total
surplus both before and after the imposition of the tariff. Because consumer surplus declines by C
+ D + E + F while producer surplus rises by C and government revenue rises by E, the
deadweight loss is D + F. The loss of consumer surplus in the amount C + D + E + F is split up
as follows: C goes to producers, E goes to the government, and D + F is deadweight loss.
PMG
Figure 6
Consumer Surplus
Producer Surplus
Government Revenue
Total Surplus
Before Tariff
A+B+C+D+E+F
G
0
A+B+C+D+E+F+G
After Tariff
A+B
C+G
E
A+B+C+E+G
CHANGE
–(C + D + E + F)
+C
+E
–(D + F)
192 ) Chapter 9/Application: International Trade
4.
a.
For a country that imports clothing, the effects of a decline in the world price are shown
in Figure 7. The initial price is Pw1 and the initial level of imports is Qd1 – Qs1. The new
world price is Pw2 and the new level of imports is Qd2 – Qs2. The table below shows the
changes in consumer surplus, producer surplus, and total surplus. Domestic consumers
are made better off, while domestic producers are made worse off. Total surplus rises by
areas D + E + F.
Price of
Clothing
S
A
Pw1
Pw2
B
C
E
D
F
G
PMG
D
Q S2
Q S1
Q D1
Q D2
Quantity of
Clothing
Figure 7
Consumer Surplus
Producer Surplus
Total Surplus
Pw1
Pw2
A+B
C+G
A+C+G
A+B+C+D+E+F
G
A+B+C+D+E+F+G
CHANGE
C+D+E+F
–C
D+E+F
Chapter 9/Application: International Trade ) 193
b.
For a country that exports clothing, the effects of a decline in the world price are shown
in Figure 8. The initial price is Pw1 and the initial level of exports is Qs1 – Qd1. The new
world price is Pw2 and the new level of exports is Qs2 – Qd2. The table below shows the
changes in consumer surplus, producer surplus, and total surplus. Domestic consumers
are made better off, while domestic producers are made worse off. Total surplus falls by
area D.
Price of
Clothing
Pw1
Pw2
S
A
B
D
C
H
G
F
E
PMG
D
Q1d
Q2d
Q2s
Q1s
Quantity of
Clothing
Figure 8
Consumer Surplus
Producer Surplus
Total Surplus
5.
6.
Pw1
Pw2
A
B+C+D+E+F+G+H
A+C+G
A+B+C
E+F+G+H
A+B+C+E+F+G+H
CHANGE
B+C
–B – C – D
–D
a.
The world wheat price must be below the U.S. no-trade price because wheat farmers
oppose NAFTA. They oppose it because they know that when trade is allowed, the U.S.
price of wheat will decline to the world price, and their producer surplus will fall. The
world corn price must be above the U.S. no-trade price, because corn farmers support
NAFTA. They know that when trade is allowed, the U.S. price of corn will rise to the
world price, and their producer surplus will rise.
b.
Considering both markets together, NAFTA makes wheat farmers worse off and corn
farmers better off, so it is not clear whether farmers as a whole gain or lose. Similarly,
consumers of wheat gain (because the price of wheat will decline) and consumers of
corn lose (because the price of corn will rise), so consumers as a whole may either gain
or lose. However, we know that the total gains from trade are positive, so the United
States as a whole is better off.
The tax on wine from California is just like a tariff imposed by one country on imports from
another. As a result, Washington producers would be better off and Washington consumers
would be worse off. The higher price of wine in Washington means producers would produce
194 ) Chapter 9/Application: International Trade
more wine, so they would hire more workers. Tax revenue would go to the government of
Washington. So both claims are true, but it is a bad policy because the losses to Washington
consumers exceed the gains to producers and the state government.
7.
Senator Hollings is correct that the price of clothing is the world price. When trade is allowed, the
domestic price of clothing is driven to the world price. The price is lower than it would be in the
absence of trade, so consumer surplus is higher than it would be without trade and this means
that consumers do benefit from lower-priced imports.
8.
a.
Figure 9 shows the market for T-shirts in Textilia. The domestic price is $20 Once trade is
allowed, the price drops to $16 and three million T-shirts are imported.
Price of
T-shirts
S
20
A
B C
PMG
16
D
1
3
4
Quantity of
T-shirts
(millions)
Figure 9
b.
Consumer surplus increases by areas A + B + C. Area A is equal to ($4)(1 million)
+(0.5)($4)(2 million) = $8 million. Area B is equal to (0.5)($4)(2 million) = $4 million.
Area C is equal to (0.5)($4)(1 million) = $2 million. Thus, consumer surplus increases by
$14 million.
Producer surplus declines by area A. Thus, producer surplus falls by $8 million.
Total surplus rises by areas B + C. Thus, total surplus rises by $6 million.
9.
10.
a.
This statement is true. For a given world price that is lower than the domestic price,
quantity demanded will rise more when demand is elastic. Therefore, the rise in
consumer surplus will be greater when demand is elastic.
b.
This statement is false. There would be no gain from trade only if demand is perfectly
inelastic.
c.
This statement is false. As long as quantity demanded rises when trade is allowed,
consumer surplus will rise.
a.
When a technological advance lowers the world price of televisions, the effect on the
United States, an importer of televisions, is shown in Figure 10. Initially the world price
Chapter 9/Application: International Trade ) 195
of televisions is P1, consumer surplus is A + B, producer surplus is C + G, total surplus is
A + B + C + G, and the amount of imports is shown as “Imports1”. After the
improvement in technology, the world price of televisions declines to P2 (which is P1 –
100), consumer surplus increases by D + E + F, producer surplus declines by C, total
surplus rises by D + E + F, and the amount of imports rises to “Imports2”.
Price of
Televisions
S
A
B
P1
P1 – 100 = P2
C
E
D
F
D
Import1
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400
200
1,000
1,200
Quantity of
Televisions
(thousands)
Import2
Figure 10
Consumer Surplus
Producer Surplus
Total Surplus
b.
P1
P2
A+B
C+G
A+B+C+G
A+B+C+D+E+F
G
A+B+C+D+E+F+G
CHANGE
C+D+E+F
–C
D+E+F
The areas are calculated as follows: Area C = 200,000($100) + (0.5)(200,000)($100)
= $30 million. Area D = (0.5)(200,000)($100) = $10 million. Area E = (600,000)($100)
= $60 million. Area F = (0.5)(200,000)($100) = $10 million.
Therefore, the change in consumer surplus is $110 million. The change in producer
surplus is -$30 million. Total surplus rises by $80 million.
c.
If the government places a $100 tariff on imported televisions, consumer and producer
surplus would return to their initial values. That is, consumer surplus would fall by areas
C + D + E + F (a decline of $110 million). Producer surplus would rise by $30 million.
The government would gain tariff revenue equal to ($100)(600,000) = $60 million. The
deadweight loss from the tariff would be areas D and F (a value of $20 million). This is
not a good policy from the standpoint of U.S. welfare because total surplus is reduced
after the tariff is introduced. However, domestic producers will be happier as they benefit
from the tariff.
d.
It makes no difference why the world price dropped in terms of our analysis. The drop in
the world price benefits domestic consumers more than it harms domestic producers and
total welfare improves.
196 ) Chapter 9/Application: International Trade
11.
Answers will vary. In general, most disputes concern imports of products. The winners from free
trade in these cases will be domestic consumers, who are able to buy products at lower prices.
The losers in this situation are domestic producers who must accept a lower price for their
products. When domestic producers lower production as a result of increased foreign
competition, some workers may be laid off or face reductions in compensation.
12.
An export subsidy increases the price of steel exports received by producers by the amount of
the subsidy, s, as shown in Figure 11. The figure shows the world price, PW, before the subsidy is
put in place. At that price, domestic consumers buy quantity Q1D of steel, producers supply Q1S
units, and the country exports the quantity Q1S – Q1D. With the subsidy put in place, suppliers get
a total price per unit of PW + s, because they receive the world price for their exports PW, and the
government pays them the subsidy of s. However, note that domestic consumers can still buy
steel at the world price, PW, by importing it. Domestic firms do not want to sell steel to domestic
customers, because they do not get the subsidy for doing so. So domestic companies will sell all
the steel they produce abroad, in total quantity Q2S. Domestic consumers continue to buy
quantity Q1D. The country imports steel in quantity Q1D and exports the quantity Q2S, so net
exports of steel are the quantity Q2S – Q1D. The end result is that the domestic price of steel is
unchanged, the quantity of steel produced increases, the quantity of steel consumed is
unchanged, and the quantity of steel exported increases. As the following table shows, consumer
surplus is unaffected, producer surplus rises, government revenue declines, and total surplus
declines.
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Thus, it is not a good policy from an economic standpoint because there is a decline in total
surplus.
Figure 11
Consumer Surplus
Producer Surplus
Government Revenue
Total Surplus
Without Subsidy
A+B
E+F+G
0
A+B+E+F+G
With Subsidy
A+B
B+C+E+F+G
–(B + C + D)
A+B–D+E+F+G
CHANGE
0
+(B + C)
–(B + C + D)
–D
Chapter 10
Externalities
10
EXTERNALITIES
WHAT’S NEW IN THE FOURTH EDITION:
The concept of positive externalities is more clearly explained with a new example. The text now clarifies
the distinction between command-and-control and market-based policies to deal with externalities. The
term “corrective tax” is now used in place of “Pigovian tax.” The section on tradable permits has a new
discussion of the performance of this program in the United States. There are two new In the News
boxes on “Conserving Fuel” and “Controlling Carbon.”
PMG
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
¾
what an externality is.
¾
why externalities can make market outcomes inefficient.
¾
how people can sometimes solve the problem of externalities on their own.
¾
why private solutions to externalities sometimes do not work.
¾
the various government policies aimed at solving the problem of externalities.
CONTEXT AND PURPOSE:
Chapter 10 is the first chapter in the microeconomic section of the text. It is the first chapter in a threechapter sequence on the economics of the public sector. Chapter 10 addresses externalities—the
uncompensated impact of one person’s actions on the well-being of a bystander. Chapter 11 will address
public goods and common resources (goods that will be defined in Chapter 11) and Chapter 12 will
address the tax system.
In Chapter 10, different sources of externalities and a variety of potential cures for externalities
are addressed. Markets maximize total surplus to buyers and sellers in a market. However, if a market
generates an externality (a cost or benefit to someone external to the market) the market equilibrium
may not maximize the total benefit to society. Thus, in Chapter 10 we will see that while markets are
usually a good way to organize economic activity, governments can sometimes improve market
outcomes.
197
198 ) Chapter 10/Externalities
KEY POINTS:
1. When a transaction between a buyer and seller directly affects a third party, that effect is called an
externality. If an activity yields negative externalities, such as pollution, the socially optimal quantity
in a market is less than the equilibrium quantity. If an activity yields positive externalities, such as
technology spillovers, the socially optimal quantity is greater than the equilibrium quantity.
2. Those affected by externalities can sometimes solve the problem privately. For instance, when one
business confers an externality on another business, the two businesses can internalize the
externality by merging. Alternatively, the interested parties can solve the problem by negotiating a
contract. According to the Coase theorem, if people can bargain without cost, then they can always
reach an agreement in which resources are allocated efficiently. In many cases, however, reaching a
bargain among the many interested parties is difficult, so the Coase theorem does not apply.
3. When private parties cannot adequately deal with external effects, such as pollution, the government
often steps in. Sometimes the government prevents socially inefficient activity by regulating behavior.
Other times it internalizes an externality using corrective taxes. Another way to protect the
environment is for the government to issue a limited number of pollution permits. The end result of
this policy is largely the same as imposing corrective taxes on polluters.
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CHAPTER OUTLINE:
I.
Definition of externality: the uncompensated impact of one person’s actions on the
well-being of a bystander.
A.
If the impact on the bystander is adverse, we say that there is a negative externality.
B.
If the impact on the bystander is beneficial, we say that there is a positive externality.
Give students several examples of both positive and negative externalities. Use
current health debates or political topics to maintain interest.
C.
II.
In either situation, decisionmakers fail to take account of the external effects of their
behavior.
Externalities and Market Inefficiency
Figure 1
A.
Welfare Economics: A Recap
1.
The demand curve for a good reflects the value of that good to consumers,
measured by the price that the marginal buyer is willing to pay.
2.
The supply curve for a good reflects the cost of producing that good.
Chapter 10/Externalities ) 199
3.
B.
In a free market, the price of a good brings supply and demand into balance in a
way that maximizes total surplus (the difference between the consumers’
valuation of the good and the sellers’ cost of producing it).
Negative Externalities
Activity 1—Everyone “Enjoys” a Good Cigar
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Negative externalities
A cigar (and lighter)
3 minutes
Works best in classes with 50 or fewer students
Purpose
This helps students understand external costs and why externalities cause nonoptimal
outcomes. It also illustrates externalities in consumption.
Instructions
Light the cigar and smoke it. Blow as much smoke as possible at the students. Tell the class
how enjoyable the cigar is. (Because most campuses prohibit smoking indoors, you may have
to just threaten to light the cigar.)
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As the room fills with smoke, explain that you intend to bring a cigar to class everyday,
because it gives so much pleasure. Ask if anyone has objections.
Common Answers and Points for Discussion
Most of the class will object to daily exposure to cigar smoke. Secondhand smoke is a
negative externality, imposing costs on the class. The smoker’s decision, based on his or her
own pleasure, ignores these external costs. The private decision will not be optimal.
This demonstration could be done using other irritants besides cigar smoke. A loud radio
could be played during the lecture. Garlic bread or crackers could be offered to half the
students. Again, the private decisions will not lead to a socially optimal outcome.
If the class is large enough, there will frequently be a small group of students who chat
during lecture. They can be used as an example of negative externalities. Their decision to
talk is based on their own private enjoyment, disregarding the external cost they impose on
their classmates. Once again, private decisions lead to an inefficient outcome.
Figure 2
1.
Example: An aluminum firm emits pollution during production.
ALTERNATIVE CLASSROOM EXAMPLE:
A coal-fired power plant.
2.
Social cost is equal to the private cost to the firm of producing the aluminum plus
the external costs to those bystanders affected by the pollution. Thus, social cost
exceeds the private cost paid by producers.
200 ) Chapter 10/Externalities
3.
The optimal amount of aluminum in the market will occur where total surplus is
maximized.
a.
Total surplus is equal to the value of aluminum to consumers minus the
cost (social cost) of producing it.
b.
This will occur where the social cost curve intersects with demand curve.
At this point, producing one more unit would lower total surplus because
the value to consumers is less than the cost to produce it.
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4.
Because the supply curve does not reflect the true cost of producing aluminum,
the market will produce more aluminum than is optimal.
Make sure that students understand how this pollution by the firm imposes costs on
third parties. Point out that the firm is likely emitting pollution because this is the
cheapest method of production. Stress that the firm is using a resource in production
that it is not paying for.
5.
This negative externality could be internalized by a tax on producers for each
unit of aluminum sold.
6.
Definition of internalizing an externality: altering incentives so that
people take account of the external effects of their actions.
This is a good time to discuss why the government taxes goods like alcohol, tobacco,
and gasoline. You will find that students have heard the phrase “sin tax,” but they
often do not understand why economists might support such taxes (given the
deadweight loss from taxes discussed in Chapter 8).
Chapter 10/Externalities ) 201
Activity 2—Externalities on a River
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Negative externalities
None
10 minutes
Works in any size class
Purpose
This helps students understand who bears external costs and why externalities are a type of
market failure.
Instructions
Draw a simple picture of a river. (Two curving lines are sufficient.) Add a rectangle labeled
“FACTORY” at one end of the river. Draw a stick figure farther down the river. Add rectangle
labeled “BREWERY” at the other end of the river.
Replace the names in the example below with names of students.
“This drawing represents three users of a natural resource. Tiffany owns a sweater factory on
the river. Dan enjoys going to a beach on the river. Pat owns a brewery that uses water from
the river.”
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Draw a line into the Brewery from the river. Add a beach umbrella for Dan. Draw a discharge
pipe from the Factory to the river.
“Let’s look at the market for Tiffany’s Sweaters. The demand for these sweaters will be based
on consumers’ tastes, incomes, the prices of substitutes and complements, and the number of
consumers in the market.”
Graph a normal downward-sloping demand curve.
“The supply curve for Tiffany’s Sweaters is based on the costs of producing sweaters.”
Add an upward-sloping supply curve to the graph. Label this “Supply with All Costs.”
Ask the class how the supply curve would shift if Tiffany got her materials for free. Then ask
them how the curve would shift if she did not have to pay her workers. The supply curve
would shift to the right in either case.
“Of course these labor and material costs are hard to avoid, but there are costs of production
that firms can avoid paying.”
Explain that a by-product of sweater production is toxic sludge. Draw thick lines representing
this sludge from the factory’s discharge pipe. This sludge is dumped in the river. Draw more
thick lines of sludge over the stick figure and into the brewery.
“Dan’s day at the beach is ruined. He’s covered with goop. Pat’s beer is ruined. The entire
production run has been contaminated. These are real costs associated with Tiffany’s sweater
production, but Dan and Pat pay these costs. Tiffany does not consider these external costs
when making supply decisions.”
Return to the supply and demand graph. Draw a new supply curve to the right of the original
curve. Label the new curve “Supply with Private Costs.”
202 ) Chapter 10/Externalities
Points for Discussion
Avoiding external costs, such as the pollution damages, increases the supply curve just like
avoiding any other cost of production. In this case, the costs are not truly avoided, but
imposed on third parties. This causes a divergence between the socially optimal outcome and
the firm’s decision based on its private costs.
Comparing the two intersections on the graph shows: Consumers pay too low a price for
sweaters and too large a quantity is produced. If the external costs were considered, prices
would be higher and quantity lower.
There are several possible ways to improve the outcome. All involve making decisionmakers
consider the external costs. This example can be used to introduce the concepts of discharge
fees, regulation, and liability rules.
An interesting extension is to explore how changes in ownership might affect the outcome. If
the sweater factory, the beach, and the brewery were all owned by one individual then the
external costs would be considered.
C.
Positive Externalities
PMG
Figure 3
1.
Example: education.
2.
Education yields positive externalities because better-educated voters lead to a
better government. Crime rates also drop as the education level of the
population rises.
3.
In this case, the demand curve does not reflect the social value of a good.
ALTERNATIVE CLASSROOM EXAMPLE:
The purchase of a fire extinguisher when an individual lives in an apartment complex.
4.
If there is a positive externality, the social value of the good is greater than the
private value, and the optimum quantity will be greater than the quantity
produced in the market.
5.
To internalize a positive externality, the government could use a subsidy.
Make sure that students realize how heavily subsidized education is in the United
States – both primary education and secondary education.
Chapter 10/Externalities ) 203
6.
Case Study: Technology Spillovers, Industrial Policy, and Patent Protection
a.
III.
A technology spillover occurs when one firm’s research and production
efforts impact another firm’s access to technological advance.
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b.
It is difficult to measure the amounts of technology spillover that occur
and this leads to a debate over whether or not the government should
pursue policies to encourage the production of technology.
c.
Patent protection is a type of technology policy of the government
because it protects the rights of inventors who create new technologies.
Without patents, there would be less incentive to develop new ideas and
technologies.
Private Solutions to Externalities
A.
We do not necessarily need government involvement to correct externalities.
B.
The Types of Private Solutions
1.
2.
Problems of externalities can sometimes be solved by moral codes and social
sanctions.
a.
Do not litter.
b.
The Golden Rule.
Many charities have been established that deal with externalities. The
government encourages this private solution by allowing a deduction for
charitable contributions in the determination of taxable income.
a.
Sierra Club (environment).
b.
University Alumni Association (scholarships).
204 ) Chapter 10/Externalities
3.
C.
The parties involved in this externality (either the seller and the bystander or the
consumer and the bystander) can possibly enter into an agreement to correct
the externality.
The Coase Theorem
1.
Definition of Coase theorem: the proposition that if private parties can
bargain without cost over the allocation of resources, they can solve
the problem of externalities on their own.
2.
Example: Dick owns a dog Spot who disturbs a neighbor (Jane) with its barking.
a.
One possible solution to this problem would be for Jane to pay Dick to
get rid of the dog. The amount that she would be willing to pay would
be equal to her valuation of the costs of the barking. Dick would only
agree to this if Jane paid him an amount greater than the value he
places on owning Spot.
b.
Even if Jane could legally force Dick to get rid of Spot, another solution
could occur. Dick could pay Jane to let him keep the dog.
PMG
3.
D.
IV.
Whatever the initial distribution of rights, the parties involved in an externality
can solve the problem themselves and reach an efficient outcome where both
parties are better off.
Why Private Solutions Do Not Always Work
1.
Definition of transaction costs: the costs that parties incur in the process
of agreeing and following through on a bargain.
2.
Coordination of all of the interested parties may be difficult so that bargaining
breaks down. This is especially true when the number of interested parties is
large.
Public Policies Toward Externalities
A.
B.
When an externality causes a market to reach an inefficient allocation of resources, the
government can respond in two ways.
1.
Command-and-control policies regulate behavior directly.
2.
Market-based policies provide incentives so that private decisionmakers will
choose to solve the problem on their own.
Command-and-Control Policies: Regulation
1.
Externalities can be corrected by making certain behaviors either required or
forbidden.
2.
In the United States, it is the Environmental Protection Agency (EPA) that
develops and enforces regulations aimed at protecting the environment.
Chapter 10/Externalities ) 205
3.
C.
EPA regulations include maximum levels of pollution allowed or required adoption
of a particular technology to reduce emissions.
Market-Based Policy 1: Corrective Taxes and Subsidies
1.
Externalities can be internalized through the use of taxes and subsidies.
2.
Definition of corrective tax: a tax designed to induce private
decisionmakers to take account of the social costs that arise from a
negative externality.
a.
These taxes are preferred by economists over regulation, because firms
that can reduce pollution with the least cost are likely to do so (to avoid
the tax) while firms that encounter high costs when reducing pollution
will simply pay the tax.
b.
Thus, this tax allows firms that face the highest cost of reducing
pollution to continue to pollute while encouraging less pollution over all.
c.
Unlike other taxes, corrective taxes do not cause a reduction in total
surplus. In fact, they increase economic well-being by forcing
decisionmakers to take into account the cost of all of the resources being
used when making decisions.
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3.
4.
D.
In the News: Conserving Fuel
a.
Some auto executives have suggested that fuel consumption should be
reduced by increasing the tax on gasoline, rather than regulating the
production of more fuel-efficient cars.
b.
This is an article from The New York Times that discusses the reasoning
behind the viewpoints of these auto executives.
Case Study: Why Is Gasoline Taxed So Heavily?
a.
In the United States, almost half of what drivers pay for gasoline goes to
gas taxes.
b.
This is to correct for three negative externalities associated with driving:
congestion, accidents, and pollution.
Market-Based Policy 2: Tradable Pollution Permits
1.
Example: EPA regulations restrict the amount of pollution that two firms can emit
at 300 tons of glop per year. Firm A wants to increase its amount of pollution.
Firm B agrees to decrease its pollution by the same amount if Firm A pays it $5
million.
2.
Social welfare is increased if the EPA allows this situation. Total pollution remains
the same so there are no external effects. If both firms are doing this willingly, it
must make them better off.
206 ) Chapter 10/Externalities
3.
If the EPA issued permits to pollute and then allowed firms to sell them, this
would also increase social welfare. Firms that could control pollution most
inexpensively would do so and sell their permits, while those who encounter high
costs when reducing pollution would buy additional permits.
Price
Price
Supply of
Pollution Permits
Corrective
Tax
Demand for
Pollution Rights
Demand for
Pollution Rights
Q*
Quantity
Q*
Quantity
Figure 4
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4.
5.
E.
Tradable pollution permits and corrective taxes are similar in effect. In both
cases, firms must pay for the right to pollute.
a.
In the case of the tax, the government basically sets the price of
pollution and firms then choose the level of pollution (given the tax) that
maximizes their profit.
b.
If tradable pollution permits are used, the government chooses the level
of pollution (in total, for all firms) and firms then decide what they are
willing to pay for these permits.
In the News: Controlling Carbon
a.
To combat global warming, European nations regulate carbon emissions
with a system of permits.
b.
This is an article from The Financial Times that describes the effects of a
cold snap on the price of these permits.
Objections to the Economic Analysis of Pollution
Stress to students that the socially optimal level of pollution is not “zero.” Make sure
that they understand that society faces a trade-off because of the resources used to
combat pollution.
1.
Some individuals dislike the idea of allowing companies to purchase the right to
pollute.
2.
These people fail to understand that the United States has limited ability to
eliminate pollution and such elimination would come at a high opportunity cost.
Chapter 10/Externalities ) 207
3.
Economists point out that “people face trade-offs” (Principle #1) and we must
decide how much we would be willing to give up to have no pollution. It would
likely not be enough.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can be found near the end of the textbook.
1.
Examples of negative externalities include pollution, barking dogs, and consumption of alcoholic
beverages. Examples of positive externalities include restoring historic buildings, research into
new technologies, and education. (Many other examples of negative and positive externalities
are possible.) Market outcomes are inefficient in the presence of externalities because markets
produce a larger quantity than is socially desirable when there is a negative externality and a
smaller quantity than is socially desirable when there is a positive externality.
2.
Examples of private solutions to externalities include moral codes and social sanctions, charities,
and relying on the interested parties entering into contracts with one other.
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The Coase theorem is the proposition that if private parties can bargain without cost over the
allocation of resources, they can solve the problem of externalities on their own.
Private economic participants are sometimes unable to solve the problems caused by an
externality because of transactions costs or because bargaining breaks down. This is most likely
when the number of interested parties is large.
3.
The town government might respond to the externality from the smoke in three ways: (1)
regulation; (2) corrective taxes; or (3) tradable pollution permits.
Regulation prohibiting pollution beyond some level is good because it is often effective at
reducing pollution. But doing so successfully requires the government to have a lot of
information about the industries and the alternative technologies that those industries could
adopt.
Corrective taxes are a useful way to reduce pollution because the tax can be increased to get
pollution to a lower level and because the taxes raise revenue for the government. The tax is
more efficient than regulation because it gives factories economic incentives to reduce pollution
and to adopt new technologies that pollute less. The disadvantage of corrective taxes is that the
government needs to know a lot of information to pick the right tax rate.
Tradable pollution permits are similar to corrective taxes but allow the firms to trade the right to
pollute with each other. As a result, the government does not need as much information about
the firms’ technologies. The government can simply set a limit on the total amount of pollution,
issue permits for that amount, and allow the firms to trade the permits. This reduces pollution
while allowing economic efficiency. Those opposed to pollution permits argue that it is wrong to
put a price on pollution and wrong to allow even low levels of pollution, but economists have little
sympathy with these arguments.
208 ) Chapter 10/Externalities
Questions for Review
1.
Examples of negative externalities include pollution, barking dogs, and consumption of alcoholic
beverages. Examples of positive externalities include restoring historic buildings, research into
new technologies, and education. (Many other examples of negative and positive externalities are
possible.)
2.
Figure 1 illustrates the effect of a negative externality. The equilibrium quantity provided by the
market is Qmarket. Because of the externality, the social cost of production is greater than the
private cost of production, so the social-cost curve is above the supply curve. The optimal
quantity for society is Qoptimum. The private market produces too much of the good, as Qmarket is
greater than Qoptimum.
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Figure 1
3.
The patent system helps society solve the externality problem from technology spillovers. By
giving inventors exclusive use of their inventions for a certain period, the inventor can capture
much of the economic benefit of the invention. In doing so, the patent system encourages
research and technological advance, which benefits society through spillover effects.
4.
Externalities can be solved without government intervention through moral codes and social
sanctions, charities, merging firms whose externalities affect each other, or by contract.
5.
According to the Coase theorem, you and your roommate will bargain over whether your
roommate will smoke in the room. If you value clean air more than your roommate values
smoking, the bargaining process will lead to your roommate not smoking. But if your roommate
values smoking more than you value clean air, the bargaining process will lead to your roommate
smoking. The outcome is efficient as long as transaction costs do not prevent an agreement from
taking place. The solution may be reached by one of you paying off the other either not to smoke
or for the right to smoke.
6.
Corrective taxes are taxes enacted to correct the effects of a negative externality. Economists
prefer corrective taxes over regulations as a way to protect the environment from pollution
because they can reduce pollution at a lower cost to society. A tax can be set to reduce pollution
Chapter 10/Externalities ) 209
to the same level as a regulation. The tax has the advantage of letting the market determine the
least expensive way to reduce pollution. The tax gives firms incentives to develop cleaner
technologies to reduce the taxes they have to pay.
Problems and Applications
1.
The Club conveys a negative externality on other car owners because car thieves will not attempt
to steal a car with The Club visibly in place. This means that they will move on to another car.
The Lojack system conveys a positive externality because thieves do not know which cars have
this technology. Therefore, they are less likely to steal any car. Policy implications include a
subsidy for car owners that use the Lojack technology or a tax on those who use The Club.
2.
a.
The statement, "The benefits of corrective taxes as a way to reduce pollution have to be
weighed against the deadweight losses that these taxes cause," is false. In fact,
corrective taxes reduce the inefficiency of pollution by reducing the quantity of the good
being produced that has pollution as a by-product. So, corrective taxes reduce
deadweight loss; they do not increase it.
b.
The statement, "When deciding whether to levy a corrective tax on consumers or
producers, the government should be careful to levy the tax on the side of the market
generating the externality," is inaccurate. It does not matter on whom the tax is
imposed⎯the incidence of the tax will be identical. So whether the externality is caused
by the seller or the buyer of a good, a tax on either producers or consumers will lead to
the same reduction of quantity and change in the prices producers receive or consumers
pay.
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Figure 2
3.
a.
Fire extinguishers exhibit positive externalities because even though people buy them for
their own use, they may prevent fire from damaging the property of others.
b.
Figure 2 illustrates the positive externality from fire extinguishers. Notice that the social
value curve is above the demand curve and the social cost curve is the same as the
supply curve.
210 ) Chapter 10/Externalities
4.
5.
6.
c.
The market equilibrium level of output is denoted Qmarket and the efficient level of output
is denoted Qoptimum. The quantities differ because in deciding to buy fire extinguishers,
people don't account for the benefits they provide to other people.
d.
A government policy that would result in the efficient outcome would be to subsidize
people $10 for every fire extinguisher they buy. This would shift the demand curve up to
the social value curve, and the market quantity would increase to the optimum quantity.
a.
The externality is noise pollution. Ringo’s consumption of rock and roll music affects
Luciano, but Ringo does not consider that in deciding how loud he plays his music.
b.
The landlord could impose a rule that music could not be played above a certain decibel
level. This could be inefficient because there would be no harm done by Ringo playing
his music loud if Luciano is not home.
c.
Ringo and Luciano could negotiate an agreement that might, for example, allow Ringo to
play his music loud at certain times of the day. They might not be able to reach an
agreement if the transaction costs are high or if bargaining fails because each holds out
for a better deal.
If the Swiss government subsidizes cattle farming, it must be because there are externalities
associated with it. Because tourists come to Switzerland to see the beautiful countryside,
encouraging farms, as opposed to industrial development, is important to maintaining the tourist
industry. Thus, farms produce a positive externality by keeping the land beautiful and unspoiled
by development. The government's subsidy thus helps the market provide the optimal amount of
farms.
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a.
The market for alcohol is shown in Figure 3. The social value curve is below the demand
curve because of the negative externality from increased motor vehicle accidents caused
by those who drink and drive. The free-market equilibrium level of output is Qmarket and
the efficient level of output is Qoptimum.
b.
The triangular area between points A, B, and C represents the deadweight loss of the
market equilibrium. This area shows the amount by which social costs exceed social
value for the quantity of alcohol consumption beyond the efficient level.
Price of
Alcohol
Supply
(social cost)
A
Optimum
Equilibrum
B
Demand
C
Social Value
Q optimum Q market
Figure 3
Quantity of
Alcohol
Chapter 10/Externalities ) 211
7.
8.
a.
It is efficient to have different amounts of pollution reduction at different firms because
the costs of reducing pollution differ across firms. If they were all made to reduce
pollution by the same amount, the costs would be low at some firms and prohibitive at
others, imposing a greater burden overall.
b.
Command-and-control approaches that rely on uniform pollution reduction among firms
give the firms no incentive to reduce pollution beyond the mandated amount. Instead,
every firm will reduce pollution by just the amount required and no more.
c.
Corrective taxes or tradable pollution rights give firms greater incentives to reduce
pollution. Firms are rewarded by paying lower taxes or spending less on permits if they
find methods to reduce pollution, so they have the incentive to engage in research on
pollution control. The government does not have to figure out which firms can reduce
pollution the most⎯it lets the market give firms the incentive to reduce pollution on their
own.
a.
If the government knew the cost of reduction at each firm, it would have Acme eliminate
all its pollution (at a cost of $10 per ton times 100 tons = $1,000) and have Creative
eliminate half of its pollution (at a cost of $100 per ton times 50 tons = $5,000). This
minimizes the total cost ($6,000) of reducing the remaining pollution to 50 tons.
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b.
If each firm had to reduce pollution to 25 tons (so each had to reduce pollution by 75
tons), the cost to Acme would be 75 x $10 = $750 and the cost to Creative would be 75
x $100 = $7,500. The total cost would be $8,250.
c.
In Part a, it costs $6,000 to reduce total pollution to 50 tons, but in Part b it costs
$8,250. So it is definitely less costly to have Acme reduce all of its pollution and have
Creative cut its pollution in half. Even without knowing the costs of pollution reduction,
the government could achieve the same result by auctioning off pollution permits that
would allow only 50 tons of pollution. This would ensure that Acme reduced its pollution
to zero (because Creative would outbid it for the permits) and Creative would then
reduce its pollution to 50 tons.
212 ) Chapter 10/Externalities
9.
a.
An improvement in the technology for controlling pollution would reduce the demand for
pollution rights, shifting the demand curve to the left. Figure 4 illustrates what would
happen if there were a corrective tax, while Figure 5 shows the impact if there were a
fixed supply of pollution permits. In both figures, the curve labeled D1 is the original
demand for pollution rights and the curve labeled D2 is the new demand for pollution
rights after the improvement in technology.
Price of
Pollution
Corrective
Tax
P
D1
D2
Q2 Q1
Quantity of
Pollution
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Figure 4
b.
With a corrective tax, the price of pollution remains unchanged and the quantity of
pollution declines, as Figure 4 shows. With pollution permits, the price of pollution
declines and the quantity of pollution is unchanged, as Figure 5 illustrates.
Figure 5
10.
a.
In terms of economic efficiency in the market for pollution, it does not matter if the
government distributes the permits or auctions them off, as long as firms can sell the
permits to each other. The only difference would be that the government could make
money if it auctioned the permits off, thus allowing it to reduce taxes, which would help
Chapter 10/Externalities ) 213
reduce the deadweight loss from taxation. There could also be some deadweight loss
occurring if firms use resources to lobby for additional permits.
11.
12.
b.
If the government allocated the permits to firms who did not value them as highly as
other firms, the firms could sell the permits to each other so they would end up in the
hands of the firms who value them most highly. Thus, the allocation of permits among
firms would not matter for efficiency. But it would affect the distribution of wealth,
because those who got the permits and sold them would be better off.
a.
International cooperation is needed because the externality from global warming is
worldwide, so the benefits from solving the problem are worldwide. Furthermore, the
efficient solution to the problem involves minimizing the costs to society; in this case,
society means the entire world.
b.
Because it would be efficient to reduce carbon dioxide most in countries where the costs
of reducing carbon dioxide emissions are low, some compensation scheme needs to be
put in place to encourage the reduction of emissions. One possibility would be to monitor
emissions, taxing those countries whose emissions are high and using the proceeds to
subsidize those who reduce their emissions. This gives the incentive to reduce emissions
in those areas where the cost of doing so is the least. In countries where the cost of
reducing emissions is high, they will just pay the tax. A system of uniform emission
reductions would impose high costs on some countries and low costs on others, and
would not give anyone the incentive to reduce emissions beyond the mandated amount.
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a.
A permit is worth $25 to firm B, $20 to firm A, and $10 to firm C, because that is the cost
of reducing pollution by one unit. Because firm B faces the highest costs of reducing
pollution, it will keep its own 40 permits and buy 40 permits from the other firms, so that
it can still pollute 80 units. That leaves 40 permits for firms A and C. Because firm A
values them most highly, it will keep its own 40 permits. So it must be that firm C sells
its 40 permits to firm B. Thus firm B does not reduce its pollution at all, firm A reduces its
pollution by 30 units at a cost of $20 x 30 = $600, and firm C reduces its pollution by 50
units at a cost of $10 x 50 = $500. The total cost of pollution reduction is $1,100.
b.
If the permits could not be traded, then firm A would have to reduce its pollution by 30
units at a cost of $20 x 30 = $600, firm B would reduce its pollution by 40 units at a cost
of $25 x 40 = $1,000, and firm C would reduce its pollution by 10 units at a cost of $10 x
10 = $100. The total cost of pollution reduction would be $1,700, $600 higher than in
the case in which the permits could be traded.
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r 11
11
PUBLIC GOODS AND
COMMON RESOURCES
WHAT’S NEW IN THE FOURTH EDITION:
The discussions of “Basic Research” and “Fighting Poverty” have been rewritten for improved clarity.
There is a new In the News box on “A Solution to City Congestion.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
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¾
the defining characteristics of public goods and common resources.
¾
why private markets fail to provide public goods.
¾
some of the important public goods in our economy.
¾
why the cost–benefit analysis of public goods is both necessary and difficult.
¾
why people tend to use common resources too much.
¾
some of the important common resources in our economy.
CONTEXT AND PURPOSE:
Chapter 11 is the second chapter in a three-chapter sequence on the economics of the public sector.
Chapter 10 addressed externalities. Chapter 11 addresses public goods and common resources—goods
for which it is difficult to charge prices to users. Chapter 12 will address the tax system.
The purpose of Chapter 11 is to address a group of goods that are free to the consumer. When
goods are free, market forces that normally allocate resources are absent. Therefore, free goods, such as
playgrounds and public parks, may not be produced and consumed in the proper amounts. Government
can potentially remedy this market failure and improve economic well-being.
215
216 ) Chapter 11/Public Goods and Common Resources
KEY POINTS:
1. Goods differ in whether they are excludable and whether they are rival in consumption. A good is
excludable if it is possible to prevent someone from using it. A good is rival in consumption if one
person’s use of the good reduces other people’s ability to use the same unit of the good. Markets
work best for private goods, which are both excludable and rival in consumption. Markets do not
work as well for other types of goods.
2. Public goods are neither rival in consumption nor excludable. Examples of public goods include
fireworks displays, national defense, and the creation of fundamental knowledge. Because people are
not charged for their use of the public good, they have an incentive to free ride when the good is
provided privately. Therefore, governments provide public goods, making their decision about the
quantity based on cost–benefit analysis.
3. Common resources are rival in consumption but not excludable. Examples include common grazing
land, clean air, and congested roads. Because people are not charged for their use of common
resources, they tend to use them excessively. Therefore, governments try to limit the use of common
resources.
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CHAPTER OUTLINE:
I.
The Different Kinds of Goods
A.
B.
When classifying types of goods in the economy, two characteristics should be examined.
1.
Definition of excludability: the property of a good whereby a person can
be prevented from using it.
2.
Definition of rivalry in consumption: the property of a good whereby one
person’s use diminishes other people’s use.
Using these two characteristics, goods can be divided into four categories.
Figure 1
1.
Definition of private goods: goods that are both excludable and rival in
consumption.
2.
Definition of public goods: goods that are neither excludable nor rival in
consumption.
3.
Definition of common resources: goods that are rival in consumption but
not excludable.
4.
If a good is excludable but not rival in consumption, it is an example of a natural
monopoly.
Chapter 11/Public Goods and Common Resources ) 217
C.
The boundary between the categories is sometimes fuzzy. Whether goods are excludable
or rival in consumption is often a matter of degree.
Yes
Excludable?
No
D.
Rival in consumption?
Yes
No
Private Goods
Natural Monopolies
ƒ ice-cream cones
ƒ fire protection
ƒ clothing
ƒ cable TV
ƒ congested toll roads
ƒ uncongested toll roads
Common Resources
Public Goods
ƒ fish in the ocean
ƒ national defense
ƒ the environment
ƒ knowledge
ƒ congested nontoll roads ƒ uncongested nontoll roads
Public goods and common resources each create externalities because they have value
yet have no price because they are not sold in the marketplace. These external effects
imply that market outcomes will be inefficient in the absence of government involvement
or private resolutions to correct the externality.
Activity 1—Private Goods/Public Goods: A Demonstration
PMG
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Public and private goods
A candy bar
10 minutes
Works in any size class
Purpose
This example illustrates the difference between public and private goods.
Instructions
Ask for a volunteer. Give the volunteer a candy bar and ask him or her to eat it.
While the student eats the candy bar, explain that you do not want the student’s enjoyment
of the candy to be marred by taking notes. Offer to draw some beautiful artwork on the board
to increase the volunteer’s enjoyment.
Draw a picture on the board. A large poster or a slide of real artwork could be substituted.
Ask the volunteer if he or she is enjoying the candy and the art. Ask the class if they get any
enjoyment from the candy. Ask the class if they get any enjoyment from the art.
Points for Discussion
The candy bar is a private good. It is rival in consumption and excludable. Only the volunteer
gets to enjoy the candy.
The “artwork” is neither rival in consumption nor excludable. The volunteer’s enjoyment did
not diminish the enjoyment of the rest of the class. The “artwork” is a public good.
218 ) Chapter 11/Public Goods and Common Resources
II.
Public Goods
A.
Example: a fireworks display. It is not excludable because it would be nearly impossible
to keep others from viewing it and it is not rival in consumption because one person’s
enjoyment does not preclude others from enjoying the fireworks.
Other examples of public goods that may be of interest to students include highway
snow removal, flood control, and mosquito control. In all of these instances, one can
argue that government intervention is necessary in order to achieve economic
efficiency.
B.
The Free-Rider Problem
1.
It would be difficult to sell tickets to the fireworks show because it is not
excludable.
2.
Thus, some individuals would get a benefit from the show without paying for it.
3.
Definition of free rider: a person who receives the benefit of a good but
avoids paying for it.
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4.
More than likely, private individuals or firms will not produce the fireworks show
because it would not be profitable.
5.
If the social value of the fireworks show is greater than the cost of producing it,
it would be efficient for the fireworks show to be produced.
6.
C.
a.
The local government can sponsor the show and charge each of its
citizens with part of the cost (in the form of a tax).
b.
If the tax is less than the value of the fireworks display to each
individual, everyone is better off.
This is another demonstration of Principle #7: Governments can sometimes
improve market outcomes.
Some Important Public Goods
1.
National defense
2.
Basic research
3.
Programs to fight poverty
Students often incorrectly believe that all goods and services provided by the government are
public goods. An example of this is education. This would be a good example to use to
explain the meaning of excludability and rivalry in consumption.
Chapter 11/Public Goods and Common Resources ) 219
D.
E.
Case Study: Are Lighthouses Public Goods?
1.
Lighthouses are used so that ships can mark specific locations and avoid
treacherous waters.
2.
Use of a lighthouse is both nonexcludable and nonrival in consumption.
3.
Thus, most lighthouses are provided by the government.
4.
In 19th-century England, lighthouses were operated more like private goods. The
owners of local ports were charged with the service and if they did not pay, the
owner of the lighthouse simply turned off the light and ships avoided stopping in
that port.
The Difficult Job of Cost–Benefit Analysis
Point out the differences in the way a business provides and finances its products
and the way that governments do the same. This will help students see the
difference between the market process and the political process as alternative ways
of providing goods and services.
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1.
To decide whether or not it should fund a public good, the government must
conduct a study of the total benefits and costs of the good.
2.
Definition of cost-benefit analysis: a study that compares the costs and
benefits to society of providing a public good.
3.
This is very difficult to do, because measuring how much individuals will value a
specific good is problematic.
a.
Quantifying benefits is difficult using the results from a questionnaire.
b.
Respondents have little incentive to tell the truth.
4.
This difficulty implies that the efficient supply of public goods is much more
challenging than the efficient supply of private goods, because buyers of the
private good reveal its value to the sellers.
5.
Case Study: How Much Is a Life Worth?
Before talking about this section, ask students to write down the value of their lives.
Ask them how they arrived at this answer. This is a nice way to lead into the
difficulty of cost–benefit analysis.
a.
Example: the decision to place a stoplight at a busy intersection to
reduce the risk of fatal accidents.
b.
The cost is known in dollar terms. But how can we put the value of a life
in dollar terms?
220 ) Chapter 11/Public Goods and Common Resources
III.
c.
Some studies examine the value of the lifetime earnings the individual
could have made, but this implies that the life of someone who is
disabled or retired has no monetary value.
d.
Economists instead may look at the risks that individuals voluntarily take
and those that they require compensation for. Workers in risky
occupations are paid a wage premium to take these risks. This approach
gives us an idea of the value that an individual places on his or her life.
Studies have shown this value to be approximately $10 million.
Common Resources
A.
Common resources are not excludable, but they are rival in consumption. This implies
that policymakers need to be concerned about how much is used.
B.
The Tragedy of the Commons
1.
Definition of the Tragedy of the Commons: a parable that illustrates why
common resources get used more than is desirable from the standpoint
of society as a whole.
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2.
Example: small, medieval town where sheep graze on common land.
a.
Over time, as the population grows, so does the number of sheep.
b.
Given the fixed amount of land, the grass will begin to disappear
because it is being overgrazed.
c.
The townspeople will no longer be able to raise sheep because the
private incentives (using the land for free) outweigh the social incentives
(using the land carefully).
d.
This problem could have been prevented if the town had regulated the
number of sheep each farmer could have or auctioned off the right to
use the common land for grazing. Alternatively, the town could have
divided the common property between its citizens, thus turning the land
into an excludable commodity.
A more modern example is the overfishing of oceans, bays, and rivers, leading to
dangerously low seafood populations in some areas. Other examples include
excessive extraction of oil from a large pool beneath several different property
owners’ land, and congested highways.
C.
Some Important Common Resources
1.
Clean air and water
2.
Congested roads
a.
In the News: A Solution to City Congestion — London recently adopted
a policy that charges drivers who use busy roads during peak times.
Chapter 11/Public Goods and Common Resources ) 221
3.
Fish, Whales, and Other Wildlife
a.
Case Study: Why the Cow is Not Extinct – Elephants in Africa are
common resources because no one owns them. This means that no one
has an incentive to make sure that a sufficient number are preserved.
This is different from a cow, which is usually owned by a rancher. The
rancher has an incentive to ensure that the cattle population on his
ranch is maintained so that he can continue to earn a profit. Thus,
governments could actually be more successful in making sure that the
elephant is not extinct by allowing people to kill the elephants on their
own property (thus making the elephants a private good). The
landowners would then have some incentive to preserve the stock of
elephants on their land.
b.
In the News: Should Yellowstone Charge as Much as Disney World? –
National parks are somewhat of a common resource and can be
overused. This is an article from The New York Times suggesting that
congestion in national parks could be solved by raising the entrance
fees.
Activity 2—Article on the Role of Government
PMG
Type:
Topics:
Class limitations:
Take-home assignment
The role of government, market failure
Works in any size class
Purpose
This assignment gives students an opportunity to identify real-world market failures and
consider how the government can address these issues. Categorizing a real problem will help
students clearly distinguish the various types of market failure.
Instructions
This assignment is difficult for many students, particularly if they are unclear on the concept
of market failure. Not every example of government action will be appropriate for this
assignment. Students may find it easier to make a list of possible areas of market failures
before looking for an article.
Ask the students to do the following:
1.
2.
3.
4.
Find an article in a recent newspaper or magazine that illustrates market failure.
Identify the type of market failure. Is it a problem of negative externalities, positive
externalities, public goods, or common resources?
Explain how government action can improve economic efficiency.
Graph the market failure and explain the problem. Then show how the government
action will change the situation.
222 ) Chapter 11/Public Goods and Common Resources
IV.
Conclusion: The Importance of Property Rights
A.
With both public goods and common resources, the market outcome will be inefficient
because of the lack of well-defined property rights.
B.
This absence of property rights can lead to a market failure, which implies that in these
situations, governments can improve the allocation of resources and increase economic
well-being.
Activity 3—Lawless Transactions
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
The legal system and property rights
A volunteer, a paper sack
15 minutes
Works in any size class
Purpose
This example shows the importance of the legal system as part of the institutional framework
of a market system. It illustrates that even simple market transactions rely on an established
body of law. Four required elements for a legal system can be demonstrated. A legal system
needs to: 1) enforce contracts, 2) define and protect property, 3) prevent fraud, 4) define and
enforce liability.
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Instructions
Explain that the transactions in this example are only hypothetical; no money or goods will
actually be exchanged.
Ask the volunteer how much he or she would be willing to pay for a backpack.
Agree to the offered price. This represents a typical market transaction, a good in exchange
for a payment. While this transaction seems very straightforward, it won’t work without a
legal system.
Ask the volunteer, “What if you paid me, but I didn’t give you anything in exchange? Would
you be happy?” Markets won’t work if agreements are not honored. A legal system can
eliminate this problem by enforcing contracts.
Now take a backpack from another student. Give it to the volunteer. In this case, both the
buyer and seller are satisfied. The volunteer gets a backpack, the professor gets paid. Ask the
class if anyone is unhappy?
The problem here is one of property rights. The professor has appropriated another student’s
backpack. This causes several problems for market transactions. If property is not protected,
the volunteer has little incentive to buy the backpack because he or she could steal it and pay
nothing. Furthermore, the volunteer has little incentive to pay for something that could
immediately be stolen by someone else. The legal system needs to define and protect
property rights to allow market transactions to work. Return the backpack to its owner.
Now give the volunteer a paper sack. Tell the volunteer you have a legally binding contract
and you expect full payment. The problem here is misrepresentation. Legal systems can
prevent this problem by stopping fraudulent contracts.
Chapter 11/Public Goods and Common Resources ) 223
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
Public goods are goods that are neither excludable nor rival in consumption. Examples include
national defense, knowledge, and uncongested nontoll roads. Common resources are goods that
are rival in consumption but not excludable. Examples include fish in the ocean, the
environment, and congested nontoll roads.
2.
The free-rider problem occurs when people receive the benefits of a good but avoid paying for it.
The free-rider problem induces the government to provide public goods because the private
market will not produce an efficient quantity on its own. The government uses tax revenue to
provide the good, everyone pays for it, and everyone enjoys its benefits. The government should
decide whether to provide a public good by comparing the good’s costs to its benefits. If the
benefits exceed the costs, society is better off.
3.
Governments try to limit the use of common resources because one person’s use of the resource
diminishes others’ use of it. This means that there is a negative externality and people tend to
use common resources excessively.
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Questions for Review
1.
2.
An excludable good is one that people can be prevented from using. A good that is rival in
consumption is one for which one person's use of it diminishes another person's enjoyment of it.
Pizza is both excludable, because a pizza producer can prevent someone from eating it who
doesn't pay for it, and rival in consumption, because when one person eats it, no one else can
eat it.
A public good is a good that is neither excludable nor rival in consumption. An example is
national defense, which protects the entire nation. No one can be prevented from enjoying the
benefits of it, so it is not excludable, and an additional person who benefits from it does not
diminish the value of it to others, so it is not rival in consumption. The private market will not
supply the good, because no one would pay for it because they cannot be excluded from
enjoying it if they don't pay for it.
3.
Cost–benefit analysis is a study that compares the costs and benefits to society of providing a
public good. It is important because the government needs to know which public goods people
value most highly and which have benefits that exceed the costs of supplying them. It is hard to
do because quantifying the benefits is difficult to do from a questionnaire and because
respondents have little incentive to tell the truth.
4.
A common resource is a good that is rival in consumption but not excludable. An example is fish
in the ocean. If someone catches a fish, that leaves fewer fish for everyone else, so it is rival in
consumption. But the ocean is so vast, you cannot charge people for the right to fish, or prevent
them from fishing, so it is not excludable. Thus, without government intervention, people will use
the good too much, because they don't account for the costs they impose on others when they
use the good.
224 ) Chapter 11/Public Goods and Common Resources
Problems and Applications
1.
a.
(1) Police protection is a natural monopoly, because it is excludable (the police may
ignore some neighborhoods) and not rival in consumption. You could make an argument
that police protection is rival in consumption, if the police are too busy to respond to all
crimes, so that one person's use of the police reduces the amount available for others. In
that case, police protection is a private good.
(2) Snow plowing is most likely a common resource. Once a street is plowed, it is not
excludable. But it is rival in consumption, especially right after a big snowfall, because
plowing one street means not plowing another street.
(3) Education is a private good (with a positive externality). It is excludable, because
someone who does not pay can be prevented from taking classes. It is rival in
consumption, because the presence of an additional student in a class reduces the
benefits to others.
(4) Rural roads are public goods. They are not excludable and they are not rival in
consumption because they are uncongested.
(5) City streets are common resources when congested. They are not excludable,
because anyone can drive on them. But they are rival in consumption, because
congestion means that every additional driver slows down the progress of other drivers.
When they are not congested, city streets are public goods, because they are no longer
rival in consumption.
2.
3.
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b.
The government may provide goods that are not public goods, such as education,
because of the externalities associated with them.
a.
The externalities associated with public goods are positive. Because the benefits from the
public good received by one person do not reduce the benefits received by anyone else,
the social value of public goods is substantially greater than the private value. Examples
include national defense, knowledge, uncongested nontoll roads, and uncongested parks.
Because public goods are not excludable, the free-market quantity is zero, so it is less
than the efficient quantity.
b.
The externalities associated with common resources are generally negative. Because
common resources are rival in consumption but not excludable, the use of the common
resources by one person reduces the amount available for others. Because common
resources are not priced, people tend to overuse them ⎯ their private cost of using the
resources is less than the social cost. Examples include fish in the ocean, the
environment, congested nontoll roads, the Town Commons, and congested parks.
a.
Charlie is a free rider.
b.
The government could solve the problem by sponsoring the show and paying for it with
tax revenue collected from everyone.
c.
The private market could also solve the problem by making people watch commercials
that are incorporated into the program. The existence of cable TV makes the good
excludable, so it would no longer be a public good.
Chapter 11/Public Goods and Common Resources ) 225
4.
a.
Within the dorm room, the showing of a movie is a public good. None of the roommates
can be excluded from viewing the movie. Because one roommate’s viewing does not
affect the ability of another roommate to view the movie, the good is also nonrival in
consumption.
b.
The roommates should rent three movies because the value of the fourth film ($6) would
be less than the cost ($8).
c.
5.
The total cost would be $8 × 3 = $24. If the cost were divided evenly among the
roommates, each would pay $6. Orson values three movies at $18 so his surplus would
be $12. Alfred values three movies at $12 so his surplus would be $6. Woody values
three movies at $6, so his surplus would be $0. Ingmar values three movies at $3 so his
surplus is -$3. Total surplus among the three roommates would be $15.
d.
The costs could be divided up by the roommates based on the benefits they receive.
Because Orson values the movies the most, he would pay the greatest share. The
problem is that this gives each roommate an incentive to understate the value of the
movies to him.
e.
Because they are going to pay equal shares, Orson has an incentive to tell the truth
about the value he places on movies to ensure that the group rents three movies. He
values each of the movies more than his cost per movie ($2).
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f.
The optimal provision of public goods will occur if individuals do not have an incentive to
hide their valuation of a good. This means that each individual’s cost cannot be related to
his valuation.
a.
Because knowledge is a public good, the benefits of basic scientific research are available
to many people. The private firm doesn't take this into account when choosing how
much research to undertake; it only takes into account what it will earn.
b.
The United States has tried to give private firms incentives to provide basic research by
subsidizing it through organizations like the National Institute of Health and the National
Science Foundation.
c.
If it is basic research that adds to knowledge, it is not excludable at all, unless people in
other countries can be prevented somehow from sharing that knowledge. So perhaps
U.S. firms get a slight advantage because they hear about technological advances first,
but knowledge tends to diffuse rapidly.
6.
When a person litters along a highway, others bear the negative externality, so the private costs
are low. Littering in your own yard imposes costs on you, so it has a higher private cost and is
thus rare.
7.
When the system is congested, each additional rider imposes costs on other riders. For example,
when all seats are taken, some people must stand. Or if there isn't any room to stand, some
people must wait for a train that isn't as crowded. Increasing the fare during rush hour
internalizes this externality.
8.
On privately owned land, the amount of logging is likely to be efficient. Loggers have incentives
to do the right amount of logging, because they care that the trees replenish themselves and the
forest can be logged in the future. Publicly owned land, however, is a common resource, and is
likely to be overlogged, because loggers won't worry about the future value of the land.
226 ) Chapter 11/Public Goods and Common Resources
Because public lands tend to be overlogged, the government can improve things by restricting
the quantity of logging to its efficient level. Selling permits to log, or taxing logging, could be
used to reach the appropriate quantity by internalizing the externality. Such restrictions are
unnecessary on privately owned lands, because there is no externality.
9.
a.
Overfishing is rational for fishermen because they are using a common resource. They do
not bear the costs of reducing the number of fish available to others, so it is rational for
them to overfish. The free-market quantity of fishing exceeds the efficient amount.
b.
A solution to the problem could come from regulating the amount of fishing, taxing
fishing to internalize the externality, or auctioning off fishing permits. But these solutions
would not be easy to implement, because many nations have access to oceans, so
international cooperation would be necessary, and enforcement would be difficult,
because the sea is so large that it is hard to police.
c.
By giving property rights to countries, the scope of the problem is reduced, because each
country has a greater incentive to find a solution. Each country can impose a tax or issue
permits, and monitor a small area for compliance.
d.
Because government agencies (like the Coast Guard in the United States) protect
fishermen and rescue them when they need help, the fishermen aren't bearing the full
costs of their fishing. Thus, they fish more than they should.
e.
The statement, "Only when fishermen believe they are assured a long-term and exclusive
right to a fishery are they likely to manage it in the same far-sighted way as good
farmers manage they land," is sensible. If fishermen owned the fishery, they would be
sure not to overfish, because they alone would bear the costs of overfishing. This is a
case in which property rights help prevent the overuse of a common resource.
f.
Alternatives include regulating the amount of fishing, taxing fishermen, auctioning off
fishing permits, or taxing fish sold in stores. All would tend to reduce the amount of
fishing from the free-market amount toward the efficient amount.
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10.
The information is nonexcludable, because it is provided to the public free of charge. In
addition, the receipt of the information by one individual does not preclude the receipt of the
information by another. Thus, the good is nonrival in consumption. Because the good is both
nonexcludable and nonrival in consumption, it is a public good.
11.
Recognizing that there are opportunity costs that are relevant for cost–benefit analysis is the key
to answering this question. A richer community can afford to place a higher value on life and
safety. So the richer community is willing to pay more for a traffic light, and that should be
considered in cost–benefit analysis.
2
12
THE DESIGN OF THE TAX
SYSTEM
WHAT’S NEW IN THE FOURTH EDITION:
There is a new Case Study on “The Fiscal Challenges Ahead” that focuses on the expected rise in
government spending on Social Security, Medicare, and Medicaid. There is also a new In the News box
on “Tax Reform around the World.”
LEARNING OBJECTIVES:
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By the end of this chapter, students should understand:
¾
how the U.S. government raises and spends money.
¾
the efficiency costs of taxes.
¾
alternative ways to judge the equity of a tax system.
¾
why studying tax incidence is crucial for evaluating tax equity.
¾
the trade-off between efficiency and equity in the design of a tax system.
CONTEXT AND PURPOSE:
Chapter 12 is the third chapter in a three-chapter sequence on the economics of the public sector.
Chapter 10 addressed externalities. Chapter 11 addressed public goods and common resources. Chapter
12 addresses the tax system. Taxes are inevitable because when the government remedies an
externality, provides a public good, or regulates the use of a common resource, it needs tax revenue to
perform these functions.
The purpose of Chapter 12 is to build on the lessons learned about taxes in previous chapters.
We have seen that a tax reduces the quantity sold in a market, that the distribution of the burden of a
tax depends on the relative elasticities of supply and demand, and that taxes cause deadweight losses.
We expand the study of taxes in Chapter 12 by addressing how the U.S. government raises and spends
money. The difficulty of making a tax system both efficient and equitable is then discussed.
227
228 ) Chapter 12/The Design of the Tax System
KEY POINTS:
1. The U.S. government raises revenue using various taxes. The most important taxes for the federal
government are individual income taxes and payroll taxes for social insurance. The most important
taxes for state and local governments are sales taxes and property taxes.
2. The efficiency of a tax system refers to the costs it imposes on taxpayers. There are two costs of
taxes beyond the transfer of resources from the taxpayer to the government. The first is the
distortion in the allocation of resources that arises as taxes alter incentives and behavior. The second
is the administrative burden of complying with the tax laws.
3. The equity of a tax system concerns whether the tax burden is distributed fairly among the
population. According to the benefits principle, it is fair for people to pay taxes based on the benefits
they receive from the government. According to the ability-to-pay principle, it is fair for people to pay
taxes based on their capability to handle the financial burden. When evaluating the equity of a tax
system, it is important to remember a lesson from the study of tax incidence: The distribution of tax
burdens is not the same as the distribution of tax bills.
4. When considering changes in the tax laws, policymakers often face a trade-off between efficiency
and equity. Much of the debate over tax policy arises because people give different weights to these
two goals.
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CHAPTER OUTLINE:
I.
A Financial Overview of the U.S. Government
In order for this material to be relevant, you will want to update it from time to time.
Data on government receipts and expenditures can be found easily on the Internet or
through the most recent edition of the Economic Report of the President.
A.
Figure 1 shows the level of government revenue in the United States, including federal,
state, and local governments, as a percentage of total income for the U.S. economy.
Figure 1
B.
1.
The role of government has grown substantially over the past century.
2.
The government’s revenue from taxation has grown at a faster rate than the
economy’s level of income.
Table 1 compares the tax burden for several major countries, as measured by the central
government’s tax revenue as a percentage of the nation’s total income.
Table 1
1.
The United States falls in the middle of the list.
Chapter 12/The Design of the Tax System ) 229
2.
C.
Tax burden in the United States is low when compared with that of European
countries, but is high when compared with that of other areas of the world.
The Federal Government
1.
Receipts
a.
Table 2 reports the receipts of the federal government in 2004.
b.
Total receipts were $1,880 billion or $6,397 per person.
c.
The largest source of revenue is the individual income tax.
d.
A family’s income tax liability is how much it owes in taxes based on
income. This tax is not proportional to income. It is based on income
minus deductions, and the tax rate rises as income rises. Table 3
presents federal tax rates for 2004.
Table 2
Table 3
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e.
2.
Other important revenue sources include payroll taxes (social insurance
taxes), the corporate income tax, and excise taxes.
Spending
a.
Table 4 reports where the federal government spent its budget in 2004.
b.
Total spending was $2,292 billion or $7,798 per person.
c.
The largest category of expenditure is Social Security. The second
largest expense is national defense.
d.
Other important categories of expenditure include income security
programs, Medicare, and net interest on the federal debt.
Table 4
3.
Definition of budget deficit: an excess of government spending over
government receipts.
4.
Definition of budget surplus: an excess of government receipts over
government spending.
Activity 1—Alphabet Soup: The Role of the Government
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
The role of government
None
15 minutes
Works in any size class
230 ) Chapter 12/The Design of the Tax System
Purpose
This assignment shows that many government activities exist in a market economy.
Instructions
Ask the students to list as many government-provided goods and services as possible. They
should include activities at the federal, state, and local levels.
Then ask them to list all the “alphabet” agencies (FBI, CIA, USDA, etc.).
The most important question to ask is “WHY?” Why, in a predominantly market economy,
does the government play so many roles?
Common Answers and Points for Discussion
Students should be able to list dozens of government activities and nearly as many agencies.
The rationale for government action can include:
• Creating an institutional framework for markets (laws, courts, money, SEC)
• Addressing market failure (national defense, education, highways, EPA)
• Addressing monopoly (antitrust, public utilities, FTC)
• Addressing equity and income distribution (Social Security, food stamps)
• Macroeconomic stability (fiscal policy, monetary policy)
• Financing the above activities (taxes, bonds, IRS).
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D.
E.
Case Study: The Fiscal Challenge Ahead
1.
In 2004, the federal government had a budget deficit of $412 billion.
2.
Long-term projections of the government’s budget show that this is expected to
rise dramatically in the decades ahead.
The population ages 65 and older is growing; thus, Medicare and Social
Security expenditures will rise as well.
b.
In addition, the costs of Medicare are affected by the rising cost of
medical care.
State and Local Government
1.
Table 5
a.
Receipts
a.
Table 5 reports the receipts from state and local governments for 2002.
b.
Total receipts were $1,685 billion or $5,733 per person.
c.
The two most important taxes for state and local governments are sales
taxes and property taxes.
d.
State and local governments also levy individual and corporate income
taxes.
Chapter 12/The Design of the Tax System ) 231
e.
2.
Spending
a.
Table 6 shows how state and local governments spent their budgets in
2002.
b.
The largest category of spending was education, while the second
largest category was public welfare.
Table 6
II.
State governments also receive funding from the federal government.
Taxes and Efficiency
A.
Well-designed tax policies minimize the deadweight losses that occur when taxes distort
incentives. They also minimize the administrative burdens that taxpayers face when
complying with tax laws.
B.
Deadweight Losses
1.
Taxes lead to deadweight losses because they lower total surplus.
Provide students with several examples of how taxes lead to an inefficient outcome.
Some examples to discuss include an inefficient shifting of productive activity from
the market sector to the household sector, diminished saving, and increased leisure.
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2.
C.
Case Study: Should Income or Consumption Be Taxed?
a.
Because interest income is taxed, the current income tax laws
discourage saving.
b.
If consumption (instead of income) is taxed, this disincentive disappears.
c.
European nations tend to rely more on consumption taxes than does the
United States.
Administrative Burden
1.
The current tax system is quite burdensome because of the large amount of
paperwork required both when filling out tax forms and keeping records
throughout the year.
For most undergraduate students, this burden may seem somewhat trivial. Use some
real-world examples of actual compliance costs to underscore this important aspect
of taxation. Use some personal examples if appropriate.
2.
Many taxpayers spend resources hiring accountants and tax lawyers.
a.
People often need help filling out complex tax forms.
b.
Individuals may also want to learn how to arrange their affairs to reduce
their tax burden.
232 ) Chapter 12/The Design of the Tax System
D.
Marginal Tax Rates versus Average Tax Rates
1.
Definition of average tax rate: total taxes paid divided by total income.
2.
Definition of marginal tax rate: the extra taxes paid on an additional
dollar of income.
3.
The average tax rate measures the sacrifice made by a taxpayer; the marginal
tax rate measures how much the tax system distorts incentives.
ALTERNATIVE CLASSROOM EXAMPLE:
Income = $30,000
Tax Brackets
$0–$10,000
$10,001 +
Tax Rate:
0%
15%
Tax liability = (0.15)($20,000) = $3,000
Average tax rate = $3,000/$30,000 = 10%
Marginal tax rate = 15%
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E.
F.
Case Study: Iceland’s Natural Experiment
1.
Until 1987, individuals in Iceland paid taxes based on their income in the
previous year. Beginning in 1988, however, taxes began to be based on current
income.
2.
This means that income for 1987 was never taxed. The marginal tax rate for
income earned during this year was zero.
3.
Total hours worked rose in 1987 by 3% and fell back to its normal level in 1988.
Real GDP was 4% higher in 1987 than the average of the year before and the
year after.
Lump-Sum Taxes
1.
Definition of lump-sum tax: a tax that is the same amount for every
person.
2.
For this type of tax, the marginal tax rate is equal to zero.
3.
This is the most efficient type of tax because it does not distort incentives and
thus has no effect on total surplus. There is also little administrative burden with
this type of tax.
4.
However, a lump-sum tax would take the same amount from the poor and the
rich, which most people would view as unfair.
Chapter 12/The Design of the Tax System ) 233
III.
Taxes and Equity
A.
B.
The Benefits Principle
1.
Definition of benefits principle: the idea that people should pay taxes
based on the benefits they receive from government services.
2.
This principle tries to make public goods similar to private goods.
3.
An example of this would be the tax on gasoline, especially if revenues from the
tax are used to build or maintain roads.
The Ability-to-Pay Principle
1.
Definition of ability-to-pay principle: the idea that taxes should be levied
on a person according to how well that person can shoulder the
burden.
2.
Definition of vertical equity: the idea that taxpayers with a greater
ability to pay taxes should pay larger amounts.
Table 7
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a.
Three tax systems: proportional, regressive, and progressive.
b.
Definition of proportional tax: a tax for which high-income and
low-income taxpayers pay the same fraction of income.
c.
Definition of regressive tax: a tax for which high-income
taxpayers pay a smaller fraction of their income than do lowincome taxpayers.
d.
Definition of progressive tax: a tax for which high-income
taxpayers pay a larger fraction of their income than do lowincome taxpayers.
e.
Case Study: How the Tax Burden Is Distributed – Table 8 shows that the
tax burden in this country is highly progressive. In addition, studies have
shown that, if transfer payments are also taken into account, the degree
of progressivity is substantial.
f.
In the News: Tax Reform around the World – Over the past decade, an
increasing number of countries have adopted a flat tax. This is an article
from The Economist describing this trend.
Table 8
3.
Definition of horizontal equity: the idea that taxpayers with similar
abilities to pay taxes should pay the same amount.
a.
Case Study: Horizontal Equity and the Marriage Tax – If a man and
a woman have similar incomes, their total tax liability increases if they
get married.
C.
Tax Incidence and Tax Equity
1.
The burden of a tax is not always borne by who pays the tax bill.
234 ) Chapter 12/The Design of the Tax System
2.
Example: tax on fur coats. This will ultimately affect those who sell and produce
the fur coats because the quantity of fur coats demanded will fall due to the
increase in price.
Activity 2—A Flat Tax?
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class activity
Progressive, regressive, proportional taxes
None
3 minutes
Works in any size class
Purpose
This activity emphasizes the importance of looking at percentages when classifying a tax as
progressive, regressive, or proportional.
Ask them is classify this tax as progressive, regressive, or proportional.
Common Answers and Points for Discussion
Many students erroneously see this head tax as proportional. A simple example can show its
regressive nature.
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Compare a low-income student who earns only $1,000 washing dishes at a summer job to a
high-income university president who earns $100,000 for running the school. Each are
required to pay $1,000 for this tax. For the student, the effective tax rate would be 100%. For
the president, the effective tax rate would be 1%.
A head tax taxes low income individuals at a higher percentage of their incomes and taxes
high-income individuals at a lower percentage. This is a regressive tax.
It may help to point out that low-income earners pay a lower dollar amount when taxes are
proportional. Using the same example, if the student paid $10 and the university president
paid $1,000 then the tax would be proportional.
This example can be used to introduce other types of taxes with regressive impacts, such as
sales taxes on food or cigarettes.
3.
IV.
Case Study: Who Pays the Corporate Income Tax?
a.
The corporate income tax is popular among voters because a corporation
is nonhuman and faceless.
b.
However, the burden of the corporate tax falls on stockholders,
customers, and workers.
c.
An increase in corporate taxes means an increase in the cost of
producing the product. Firms will cut back production (which lowers
supply and raises the price to the consumer) and possibly lay off workers
(which causes unemployment, lower wages, or both).
Conclusion: The Trade-off Between Equity and Efficiency
Chapter 12/The Design of the Tax System ) 235
Activity 3—Tax Alternatives
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
Taxes and fairness
None
20 minutes
Works in any size class
Purpose
The impact of taxes can be examined in a variety of ways. This exercise helps students think
about the different effects of taxes on different goods. Taxes that may be appealing because
they minimize deadweight loss may be undesirable for equity reasons.
Instructions
Tell the class, “The state has decided to increase funding for public education. They are
considering four alternative taxes to finance these expenditures. All four taxes would raise the
same amount of revenue.” List these options on the board:
1.
2.
3.
4.
A sales tax on food
A tax on families with school-age children
A property tax on vacation homes
A sales tax on jewelry
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Ask the students to answer the following questions. Give them time to write an answer, then
discuss their answers before moving to the next question:
A.
B.
C.
D.
Analyze these taxes using the benefits principle.
Analyze these taxes using the principle of horizontal equity.
Classify each tax as progressive, proportional, or regressive.
Which tax would you choose to finance education? Explain.
Common Answers and Points for Discussion
A.
Are the taxes related to the benefits received?
1.
A sales tax on food: This broad-based tax would be appropriate if citizens, as a
whole, receive benefits from education. To the extent that education provides
positive externalities, this tax could be justified on the benefits principle.
2.
A tax on families with school-age children: This tax burden would be borne
mainly by those who have the highest benefits. The exceptions would be families
who choose private schools or home schooling; these households would pay the
taxes but not receive the benefits.
3.
A property tax on vacation homes: This tax is probably the worst from a benefits
perspective. Many vacation homeowners may be from other states and receive
minimal, if any, benefits from supporting education.
4.
A tax on jewelry: This tax is also weak from the benefits perspective. There is
little reason to think jewelry buyers would disproportionately benefit from better
public education.
236 ) Chapter 12/The Design of the Tax System
B.
Are taxes the same for households earning the same income?
None of these taxes is horizontally equitable. They fall disproportionately on
households who:
1.
buy more food.
2.
have school-age children.
3.
own vacation homes.
4.
buy jewelry.
The food tax might be the best from this perspective.
C.
Vertical equity
1.
A sales tax on food
Regressive—lower income households spend a larger portion of their income on food.
2.
A tax on families with school-age children.
Regressive—lump-sum taxes have a bigger percentage impact on low incomes.
3.
A property tax on vacation homes.
Progressive—higher income households are more likely to own vacation homes, and
to own more expensive vacation properties.
4.
A sales tax on jewelry
Progressive—higher income households will typically buy more expensive jewelry.
D.
Which Tax?
No single tax satisfies all equity concerns. If market distortions are also considered,
the decision becomes more complex. This question can generate good discussion
about the trade-offs between different taxes. Many times students will volunteer
additional tax options—income taxes are a common suggestion.
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SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
The two most important sources of tax revenue for the federal government are individual income
taxes and payroll taxes (social insurance taxes). The two most important sources of tax revenue
for state and local governments are sales taxes and property taxes.
2.
The efficiency of a tax system depends on the costs of collecting a given amount of tax revenue.
One tax system is more efficient than another if the same amount of tax revenue can be raised
at a lower cost.
A tax system can be inefficient because of the deadweight losses that result when taxes distort
the decisions that people make and because of the administrative burdens that taxpayers bear as
they comply with tax laws. An efficient tax system has low deadweight losses and small
administrative burdens.
3.
The benefits principle is the idea that people should pay taxes based on the benefits they receive
from government services. It tries to make public goods similar to private goods by making
those who benefit more from the public good pay more for it. The ability-to-pay principle is the
Chapter 12/The Design of the Tax System ) 237
idea that taxes should be levied on a person according to how well that person can shoulder the
burden. It tries to equalize the sacrifice each person makes toward paying taxes.
Vertical equity is the idea that taxpayers with greater ability to pay taxes should pay larger
amounts. Horizontal equity is the idea that taxpayers with similar abilities to pay taxes should
pay the same amount.
Studying tax incidence is important for determining the equity of a tax system because
understanding how equitable the tax system is requires understanding the indirect effects of
taxes. In many cases, the burden of the tax is borne by individuals other than those who
actually pay the tax.
Questions for Review
1.
Over the past several decades, government has grown more rapidly than the rest of the
economy. The ratio of government revenue to GDP has increased over time.
2.
The two most important sources of revenue for the U.S. federal government are individual
income taxes (about 43% of total revenue) and social insurance taxes (about 39%).
3.
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4.
5.
Corporate profits are taxed first when the corporate income tax is taken out of a corporation's
income. When the profits are used to pay dividends to the corporation's shareholders, they are
taxed again through individual income tax.
The burden of a tax to taxpayers is greater than the revenue received by the government
because: (1) taxes impose deadweight losses by reducing the quantity of goods produced and
purchased below their efficient level; and (2) taxes entail a costly administrative burden on
taxpayers.
Some economists advocate taxing consumption rather than income because taxing income
discourages saving. A consumption tax would not distort individuals’ saving decisions.
6.
Wealthy taxpayers should pay more taxes than poor taxpayers should because: (1) they benefit
more from public services; and (2) they have a greater ability to pay.
7.
Horizontal equity refers to the idea that families in the same economic situation should be taxed
equally. The concept of horizontal equity is hard to apply because families differ in many ways,
so it is not obvious how to tax them equitably. For example, two families with the same income
may have different numbers of children and different levels of medical expenses.
Problems and Applications
1.
The federal government had a budget deficit in 2004. As of 2005, policymakers expected budget
deficits over the next decade.
2.
a.
The increase in revenue of the total government is attributable more to increases in state
and local government revenue than to federal government revenue. In 1960, state and
local government revenue was 33% of total government revenue; by 2003, it had risen
to almost 52%.
238 ) Chapter 12/The Design of the Tax System
3.
b.
Personal income taxes account for a bit less of the total revenue of federal and state and
local governments now (34% in 1960, 32% in 2003); social insurance taxes account for
a substantially greater proportion (12% in 1960, 26% in 2003); and corporate taxes
account for a lower proportion (17% in 1960, 7% in 2003).
c.
Transfer payments now account for a much greater proportion of the total expenditures
of federal and state and local governments (23% in 1960, 40% in 2003), while
purchases account for a much smaller proportion (68% in 1960, 50% in 2003).
a.
If the number of retirees is rising and total expenditures are frozen, then benefits per
retiree will decline over time. Because the number of workers is rising, albeit slowly, tax
payments per worker would decline slowly over time.
b.
If benefits per retiree were frozen, total expenditures would rise quickly, along with the
number of retirees. To pay for the increased expenditures, tax payments per worker
would rise, because the number of workers isn't growing as rapidly as the number of
retirees.
c.
If tax payments per worker were frozen, total expenditures would rise slowly, at the
same rate as the growth rate of the number of workers. Because the number of retirees
is rising more rapidly, benefits per retiree would decline over time.
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d.
4.
The answers to Parts (a), (b), and (c) suggest there is no easy solution. Either workers
will pay more per person or retirees will get fewer benefits per person. Policymakers may
eventually be forced to compromise, both reducing benefits per retiree and increasing
tax payments per worker.
If you earn $20,000 a year, then you pay federal income taxes in two parts: 10% on the first
$7,150 of income and 15% on the amount above $7,150. Thus, your federal income taxes are
($7, 150 x 0.10) + ($12,850 × 0.15) = $715 + $1,927.50 = $2,642.50. You also pay $20,000 x
0.153 = $3,060 in federal payroll taxes and $20,000 x 0.04 = $800 in state income taxes, for a
total tax bill of $6,502.50. Your average tax rate is $6,502.50/$20,000 = 0.325 = 32.5%. Your
marginal tax rate is 0.15 + 0.153 + 0.04 = 0.343 = 34.3%.
If you earn $40,000 a year, then you pay federal income taxes in three parts: 10% on the first
$7,150 of income, 15% for additional income up to $29,050, and 25% for the remaining $10,950
of income. Thus, your federal income taxes are ($7,150 x 0.10) + ($21,900 x 0.15) + ($10,950)
× 0.25) = $715 + $3,285 + $2,737.50 = $6.737.50. You also pay $40,000 x 0.153 = $6,120 in
federal payroll taxes, and $40,000 x 0.04 = $1,600 in state income taxes. Your total tax bill is
$14,457.50. Your average tax rate is $14,457.50/$40,000 = 0.361 = 36.1%. Your marginal tax
rate is 0.25 + 0.153 + 0.04 = 0.443 = 44.3%.
5.
Excluding food and clothing from the sales tax is justified on equity grounds because poor people
spend a greater proportion of their income on those items. By exempting them from taxation, the
system makes the rich bear a greater burden of taxation than the poor. From the point of view of
efficiency, however, excluding food and clothing from the sales tax is inefficient, because the
incentives to purchase food and clothing rather than other items are likely affected by this tax
exemption. This leads to an inefficient allocation of resources. In addition, because the demand
for food and clothing is likely to be relatively inelastic, the deadweight loss from a tax on these
goods would be relatively small (when compared with a tax on a good whose demand is
relatively elastic).
Chapter 12/The Design of the Tax System ) 239
6.
a.
An individual must pay taxes on the asset only when he or she sells it. Thus, this tax law
affects the individual’s decision of whether to keep or sell the asset. Tax revenues on
accrued capital gainsare only received by the government when an individual actually
sells the asset. Lowering the tax rate on capital gains may induce individuals to sell
assets that they have been holding to avoid paying the taxes on the accrued capital
gains.
b.
It is inefficient to tax only realized capital gains because it distorts the incentives an
individual faces with regard to keeping or selling a particular asset. However, it may be
difficult to estimate the rise in the value of an asset prior to its sale.
7.
If the state raises its sales tax from 5% to 6%, it is not plausible that sales tax revenue will
increase 20%. The increase in the tax rate is 20%, so the only way tax revenue could increase
20% would be if total spending didn't fall in response to the tax increase, which is unlikely.
Instead, the higher tax would raise the price of goods, so people would spend less. Thus, tax
revenue might go up, because the tax rate is higher, but by less than 20%. There is a possibility
that tax revenues will fall.
8.
The effect of the Tax Reform Act of 1986 on interest payments was to reduce consumer debt and
increase home equity debt. People started financing general expenditures through home equity
loans and paid down their mortgages less quickly.
9.
10.
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a.
The fact that visitors to many national parks pay an entrance fee is an example of the
benefits principle, because people are paying for the benefits they receive.
b.
The fact that local property taxes support elementary and secondary schools is an
example of the ability-to-pay principle, because if you own more expensive property, you
must pay more tax.
c.
The setup of airport trust funds is an example of the benefits principle, because use of
the airport generates tax revenue that pays for upkeep of the airport.
a.
For the proportional tax system, the average tax rate is 25% whether a person earns
income of $50,000, $100,000, or $200,000.
For the regressive tax system, the average tax rate is 30% for someone earning
$50,000, 25% for someone earning $100,000, and 20% for someone earning $200,000.
For the progressive tax system, the average tax rate is 20% for someone earning
$50,000, 25% for someone earning $100,000, and 30% for someone earning $200,000.
b.
For the proportional tax system, the marginal tax rate as income rises from $50,000 to
$100,000 is the increase in taxes ($12,500) divided by the increase in income ($50,000)
= 25%. The marginal tax rate as income rises from $100,000 to $200,000 is the increase
in taxes ($25,000) divided by the increase in income ($100,000) = 25%.
For the regressive tax system, the marginal tax rate as income rises from $50,000 to
$100,000 is the increase in taxes ($10,000) divided by the increase in income ($50,000)
= 20%. The marginal tax rate as income rises from $100,000 to $200,000 is the increase
in taxes ($15,000) divided by the increase in income ($100,000) = 15%.
For the progressive tax system, the marginal tax rate as income rises from $50,000 to
$100,000 is the increase in taxes ($15,000) divided by the increase in income ($50,000)
240 ) Chapter 12/The Design of the Tax System
= 30%. The marginal tax rate as income rises from $100,000 to $200,000 is the increase
in taxes ($35,000) divided by the increase in income ($100,000) = 35%.
c.
11.
In the proportional tax system, the average tax rate equals the marginal tax rate. In the
regressive tax system, the marginal tax rate is less than the average tax rate and both
tax rates decline as income rises. In the progressive tax system, the marginal tax rate is
greater than the average tax rate and both tax rates rise as income rises. The marginal
tax rate is relevant to someone deciding whether to accept a job that pays slightly more
than her current job, because it tells her how much of the extra income she will be able
to keep after taxes. For judging the vertical equity of the tax system, the average tax
rate is relevant, because vertical equity suggests that people with a greater ability to pay
should pay a larger amount.
a.
Income Quintile
Lowest
Second
Middle
Fourth
Highest
Federal Taxes
$819.50
$4,104.00
$8,034.00
$14,817.60
$48,050.10
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b.
From the lowest quintile to the second quintile, the change in income is $19,300 and
the change in taxes is $3,284.50.
From the second quintile to the middle quintile, the change in income is $17,300 and
the change in taxes is $3,930.
From the middle quintile to the fourth quintile, the change in income is $24,100 and
the change in taxes is $6,783.60.
From the fourth quintile to the highest quintile, the change in income is $107,100 and
the change in taxes is $33,232.50.
c.
From the lowest quintile to the second quintile, the marginal tax rate is
$3,284.50/$19,360 = 0.170 = 17.0%.
From the second quintile to the middle quintile, the marginal tax rate is $3,930/$17,300
= 0.227 = 22.7%.
From the middle quintile to the fourth quintile, the marginal tax rate is
$6,783.60/$24,100 = 0.281 = 28.1%.
From the fourth quintile to the highest quintile, the marginal tax rate is
$33,232.50/$107,100 = 0.31 = 31.0%.
12.
d.
The marginal tax rate is greater than the average tax rate for all income quintiles.
e.
The average tax rate and the marginal tax rate both rise as income rises. At lower levels
of income, the tax rate rises more quickly than the average tax rate. At higher levels of
income, the rate of increase in the average tax rate is greater.
a.
If the deduction for mortgage interest were eliminated, fewer people would desire to
hold mortgages or purchase homes. This would impact housing markets and housing
Chapter 12/The Design of the Tax System ) 241
values. The removal of this deduction will likely improve vertical equity because higher
income households tend to hold larger mortgages and thus currently get larger
deductions. It would also improve horizontal equity because homeowners would be
treated equally. Efficiency would improve for two reasons: less distortion in incentives
and a smaller amount of paperwork in filing taxes.
b.
If the deduction for state and local taxes was eliminated, the marginal tax rate on
income will rise and this reduces the incentive to work. This would lead to inefficiency.
Vertical equity would be improved, while horizontal equity would be unaffected.
c.
If the deduction for charitable contributions were eliminated, fewer dollars would be
donated to charities. This would reduce the provision of some public goods (such as
public television). Vertical equity would be improved, assuming that charitable
contributions are positively related to income. Horizontal equity would also be improved
because individuals in similar circumstances would pay the same level of taxes, whether
or not they donated to charities.
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13
THE COSTS OF PRODUCTION
WHAT’S NEW IN THE FOURTH EDITION:
The introduction to the concept of economic profit is more detailed.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
¾
what items are included in a firm’s costs of production.
¾
the link between a firm’s production process and its total costs.
¾
the meaning of average total cost and marginal cost and how they are related.
¾
the shape of a typical firm’s cost curves.
¾
the relationship between short-run and long-run costs.
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CONTEXT AND PURPOSE:
Chapter 13 is the first chapter in a five-chapter sequence dealing with firm behavior and the organization
of industry. It is important that students become comfortable with the material in Chapter 13 because
Chapters 14 through 17 are based on the concepts developed in Chapter 13. To be more specific,
Chapter 13 develops the cost curves on which firm behavior is based. The remaining chapters in this
section (Chapters 14-17) utilize these cost curves to develop the behavior of firms in a variety of different
market structures—competitive, monopolistic, oligopolistic, and monopolistically competitive.
The purpose of Chapter 13 is to address the costs of production and develop the firm’s cost
curves. These cost curves underlie the firm’s supply curve. In previous chapters, we summarized the
firm’s production decisions by starting with the supply curve. While this is suitable for answering many
questions, it is now necessary to address the costs that underlie the supply curve in order to address the
part of economics known as industrial organization—the study of how firms’ decisions about prices and
quantities depend on the market conditions they face.
KEY POINTS:
1. The goal of firms is to maximize profit, which equals total revenue minus total cost.
243
244 ) Chapter 13/The Costs of Production
2. When analyzing a firm’s behavior, it is important to include all the opportunity costs of production.
Some of the opportunity costs, such as the wages a firm pays its workers, are explicit. Other
opportunity costs, such as the wages the firm owner gives up by working in the firm rather than
taking another job, are implicit.
3. A firm’s costs reflect its production process. A typical firm’s production function gets flatter as the
quantity of an input increases, displaying the property of diminishing marginal product. As a result, a
firm’s total-cost curve gets steeper as the quantity produced rises.
4. A firm’s total costs can be divided between fixed costs and variable costs. Fixed costs are costs that
do not change when the firm alters the quantity of output produced. Variable costs are costs that do
change when the firm alters the quantity of output produced.
5. From a firm’s total cost, two related measures of cost are derived. Average total cost is total cost
divided by the quantity of output. Marginal cost is the amount by which total cost rises if output
increases by one unit.
6. When analyzing firm behavior, it is often useful to graph average total cost and marginal cost. For a
typical firm, marginal cost rises with the quantity of output. Average total cost first falls as output
increases and then rises as output increases further. The marginal-cost curve always crosses the
average-total-cost curve at the minimum of average total cost.
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7. A firm’s costs often depend on the time horizon being considered. In particular, many costs are fixed
in the short run but variable in the long run. As a result, when the firm changes its level of
production, average total cost may rise more in the short run than in the long run.
CHAPTER OUTLINE:
This is an extremely important chapter, and it is critical that students have an
understanding of the important principles developed here in order to follow the
material presented in the next several chapters. Do not be surprised at the
number of students who are unfamiliar with such seemingly simple
concepts as revenue, costs, and profits.
I.
What Are Costs?
Point out to students that it is possible for firm owners to have different goals, but
the one motive that makes the most accurate prediction about how firms behave is
the assumption of profit maximization. To help illustrate this sometimes-controversial
assumption, use the analogy of an automobile driver. Ask students to name an
assumption about the goal of most drivers. Most would agree that drivers behave as
if their goal is to get from one place to another in the least amount of time. This may
not explain the behavior of every driver (i.e., “Sunday” drivers), but it works for
most.
A.
Total Revenue, Total Cost, and Profit
1.
The goal of a firm is to maximize profit.
2.
Definition of total revenue: the amount a firm receives for the sale of its
output.
Total Revenue = Price × Quantity
Chapter 13/The Costs of Production ) 245
3.
Definition of total cost: the market value of the inputs a firm uses in
production.
Students rarely have trouble understanding the concept of explicit costs. However,
they do often have difficulty understanding the nature of implicit costs. Make sure
that they grasp the concept here, because it is important in understanding why firms
continue to operate even if they are earning zero economic profit in the long run.
4.
Definition of profit: total revenue minus total cost.
Profit = Total Revenue − Total Cost
B.
Costs as Opportunity Costs
1.
Principle #2: The cost of something is what you give up to get it.
2.
The costs of producing an item must include all of the opportunity costs of inputs
used in production.
3.
Total opportunity costs include both implicit and explicit costs.
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C.
a.
Definition of explicit costs: input costs that require an outlay of
money by the firm.
b.
Definition of implicit costs: input costs that do not require an
outlay of money by the firm.
c.
The total cost of a business is the sum of explicit costs and implicit costs.
d.
This is the major way in which accountants and economists differ in
analyzing the performance of a business.
e.
Accountants focus on explicit costs, while economists examine both
explicit and implicit costs.
The Cost of Capital as an Opportunity Cost
1.
The opportunity cost of financial capital is an important cost to include in any
analysis of firm performance.
2.
Example: Helen uses $300,000 of her savings to start her firm. It was in a
savings account paying 5% interest.
3.
Because Helen could have earned $15,000 per year on this savings, we must
include this opportunity cost. (Note that an accountant would not count this
$15,000 as part of the firm's costs.)
4.
If Helen had instead borrowed $200,000 from a bank and used $100,000 from
her savings, the opportunity cost would not change if the interest rate stayed the
same (according to the economist). But the accountant would now count the
$10,000 in interest paid for the bank loan.
246 ) Chapter 13/The Costs of Production
D.
Economic Profit versus Accounting Profit
Figure 1
II.
1.
Figure 1 highlights the differences in the ways in which economists and
accountants calculate profit.
2.
Definition of economic profit: total revenue minus total cost, including
both explicit and implicit costs.
a.
Economic profit is what motivates firms to supply goods and services.
b.
To understand how industries evolve, we need to examine economic
profit.
3.
Definition of accounting profit: total revenue minus total explicit cost.
4.
If implicit costs are greater than zero, accounting profit will always exceed
economic profit.
Production and Costs
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You may want to give students a handout that summarizes the definitions and
provides them an opportunity to practice the calculations in this chapter. (See the
alternative classroom examples.)
A.
The Production Function
1.
Definition of production function: the relationship between quantity of
inputs used to make a good and the quantity of output of that good.
It will be beneficial at this point to distinguish between the long run and the short
run. This will help students understand the distinction between fixed inputs and
variable inputs.
2.
Example: Helen's cookie factory. The size of the factory is assumed to be fixed;
Helen can vary her output (cookies) only by varying the labor used.
Table 1
Number of
Workers
0
1
2
3
4
5
6
Output
0
50
90
120
140
150
155
Marginal Product
of Labor
--50
40
30
20
10
5
Cost of
Factory
$30
30
30
30
30
30
30
Cost of
Workers
$0
10
20
30
40
50
60
Total Cost
of Inputs
$30
40
50
60
70
80
90
Go through this table, column by column. Make sure that students understand the
calculations involved.
Chapter 13/The Costs of Production ) 247
3.
Definition of marginal product: the increase in output that arises from an
additional unit of input.
Marginal Product of Labor =
change in output
change in labor
a.
As the amount of labor used increases, the marginal product of labor
falls.
b.
Definition of diminishing marginal product: the property whereby
the marginal product of an input declines as the quantity of the
input increases.
Point out that diminishing marginal returns is a result of fixed inputs and, therefore is
a short-run phenomenon.
ALTERNATIVE CLASSROOM EXAMPLE:
Consider the short-run production of a small firm that makes sweaters. These sweaters are
made using a combination of labor and knitting machines. In the short run, the firm has
signed a lease to rent one machine. Therefore, in the short run, the firm cannot vary the
amount of knitting machines it uses. However, the firm can vary the amount of labor it
employs.
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The first two columns in the table below show the production level that the firm can
achieve at various amounts of labor:
Labor (# workers)
0
1
2
3
4
5
4.
Figure 2
Total Output
0
4
10
13
15
16
Marginal Product
---4
6
3
2
1
We can draw a graph of the firm's production function by plotting the level of
labor (x-axis) against the level of output (y-axis).
248 ) Chapter 13/The Costs of Production
a.
The slope of the production function measures marginal product.
b.
Diminishing marginal product can be seen from the fact that the slope
falls as the amount of labor used increases.
If you use an overhead projector, you can show how the production function relates
to costs. Begin with the production function, assuming that labor is the only variable
input. This means that variable costs are equal to the amount of labor multiplied by
the wage rate. If you multiply the labor on the horizontal axis, you will therefore
have output on the vertical axis and variable cost on the horizontal axis. Then take
the transparency and flip it so that the variable cost is on the vertical axis with output
on the horizontal axis. Show students that this is the variable cost curve. Total cost
can be drawn by dropping the horizontal axis by the amount of fixed costs.
B.
From the Production Function to the Total-Cost Curve
1.
We can draw a graph of the firm's total cost curve by plotting the level of output
(x-axis) against the total cost of producing that output (y-axis).
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a.
The total cost curve gets steeper and steeper as output rises.
b.
This increase in the slope of the total cost curve is also due to
diminishing marginal product: As Helen increases the production of
cookies, her kitchen becomes overcrowded, and she needs a lot more
labor.
Chapter 13/The Costs of Production ) 249
Activity 1— Growing Rice on a Chalkboard
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Diminishing returns and increasing costs
two volunteers, chalkboard, chalk, two “loans”
25 minutes
Works in classes with more than 15 students
Purpose
Students often have difficulty understanding why diminishing returns exist in short-run
production. This activity vividly demonstrates how fixed factors constrain the returns to
variable inputs. Then the cause of increasing marginal cost is obvious.
Instructions
Each “loan” is a sheet of paper with a large dollar sign ($) written on one side and the word
“LOAN” on the other. Prepare the game by selecting two volunteers and outlining two
rectangular areas on the chalkboard, approximately 2 × 3 feet. Next to each area, label a
column “Labor” and another “Total Output.” Give each volunteer one piece of chalk and hide
any other pieces. The chalk is a fixed factor of production.
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The volunteers are farmers and the outlined areas are their farm fields. They produce rice by
writing the word “RICE” in large letters inside their own field. The letters need to be at least
three inches high. They want to produce as much rice as possible in each 15-second time
period.
Of course, it takes big bucks to farm (show the class the large $) and the money comes in the
form of a loan (show them the other side of the paper). Tell the volunteers, “Before you can
start producing, you will need to run to the back of the classroom and get a loan from me.”
The variable input in this example is labor. The game is played repeatedly, adding another
student each period. Eventually five students will be crowded around each “field” trying to
write with a tiny piece of chalk.
The constraints from the fixed factors are physically demonstrated.
Start the game with zeros in both the labor and total output columns; with no labor, no rice is
produced. Then have the two volunteers race to see how much they can produce in 15
seconds. Record their production under “Total Output” with one “Labor.”
III.
The Various Measures of Cost
Table 2
A.
Example: Thirsty Thelma's Lemonade Stand
B.
Fixed and Variable Costs
1.
Definition of fixed costs: costs that do not vary with the quantity of
output produced.
250 ) Chapter 13/The Costs of Production
2.
Definition of variable costs: costs that do vary with the quantity of
output produced.
3.
Total cost is equal to fixed cost plus variable cost.
TC = FC + VC
Figure 3
Output
0
1
2
3
4
5
6
7
8
9
10
Total
Cost
$3.00
3.30
3.80
4.50
5.40
6.50
7.80
9.30
11.00
12.90
15.00
Fixed
Cost
$3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
Variable
Cost
$0
0.30
0.80
1.50
2.40
3.50
4.80
6.30
8.00
9.90
12.00
Average
Fixed
Cost
--$3.00
1.50
1.00
0.75
0.60
0.50
0.43
0.38
0.33
0.30
Average
Variable
Cost
--$0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
1.10
1.20
Average
Total
Cost
--$3.30
1.90
1.50
1.35
1.30
1.30
1.33
1.38
1.43
1.50
Marginal
Cost
--$0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
1.90
2.10
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ALTERNATIVE CLASSROOM EXAMPLE:
Consider the sweater manufacturer (described earlier). The firm is currently renting one machine
for $25 per day. Each worker is also paid $25 per day.
Labor
0
1
2
3
4
5
C.
Output
0
4
10
13
15
16
Fixed
Cost
$25
25
25
25
25
25
Variable
Cost
$0
25
50
75
100
125
Total
Cost
$25
50
75
100
125
150
Average
Fixed
Cost
---$6.25
2.50
1.92
1.67
1.56
Average
Variable
Cost
---$6.25
5.00
5.77
6.67
7.81
Average
Total
Cost
---$12.50
7.50
7.69
8.33
9.38
Marginal
Cost
---$6.25
4.17
8.33
12.50
25.00
Average and Marginal Cost
1.
Definition of average total cost: total cost divided by the quantity of
output.
2.
Definition of average fixed cost: fixed costs divided by the quantity of
output.
3.
Definition of average variable cost: variable costs divided by the quantity
of output.
Chapter 13/The Costs of Production ) 251
ATC =
4.
Definition of marginal cost: the increase in total cost that arises from an
extra unit of production.
MC =
5.
D.
TC
VC
FC
; AVC =
; AFC =
Q
Q
Q
change in total cost
change in output
Average total cost tells us the cost of a typical unit of output and marginal cost
tells us the cost of an additional unit of output.
Cost Curves and Their Shapes
Figure 4
1.
Rising Marginal Cost
PMG
2.
a.
This occurs because of diminishing marginal product.
b.
At a low level of output, there are few workers and a lot of idle
equipment. But as output increases, the lemonade stand (or factory)
gets crowded and the cost of producing another unit of output becomes
high.
U-Shaped Average Total Cost
a.
Average total cost is the sum of average fixed cost and average variable
cost.
ATC = AFC + AVC
b.
AFC declines as output expands and AVC typically increases as output
expands. AFC is high when output levels are low. As output expands,
AFC declines pulling ATC down. As fixed costs get spread over a large
number of units, the effect of AFC on ATC falls and ATC begins to rise
because of diminishing marginal product.
c.
3.
Definition of efficient scale: the quantity of output that minimizes
average total cost.
The Relationship between Marginal Cost and Average Total Cost
a.
Whenever marginal cost is less than average total cost, average total
cost is falling. Whenever marginal cost is greater than average total cost,
average total cost is rising.
b.
The marginal-cost curve crosses the average-total-cost curve at
minimum average total cost (the efficient scale).
252 ) Chapter 13/The Costs of Production
Activity 3—Average and Marginal Grades
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Relationship between marginal and average cost
None
5 minutes
Works in any size class
Purpose
This quick exercise uses an analogy to illustrate to students that they already know the
relation between marginal values and averages.
Instructions
Tell the class that two twins are enrolled in Principles of Economics. They each had a “B”
average (GPA = 3.0) before taking the class.
Twin One gets a “C” in the course. What happens to her GPA?
Twin Two gets an “A” in the class. What happens to her GPA?
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Common Answers and Points for Discussion
The entire class will know that Twin One will have a lower GPA and Twin Two a higher GPA. A
“marginal” grade lower than the average will pull down the average. A “marginal” grade
higher than the average will increase the average.
The same is true of marginal cost and average costs. If marginal cost is less than average
cost, average cost will fall. If marginal cost is higher than average cost, average cost will rise.
4.
Typical Cost Curves
Figure 5
a.
Marginal cost eventually rises with output.
b.
The average-total-cost curve is U-shaped.
Chapter 13/The Costs of Production ) 253
c.
Marginal cost crosses average total cost at the minimum of average total
cost.
Emphasize that these cost curves include ALL costs for the resources needed to
produce the good. Thus, both explicit costs and implicit costs are included.
IV.
Costs in the Short Run and in the Long Run
A.
The division of total costs into fixed and variable costs will vary from firm to firm.
B.
Some costs are fixed in the short run, but all are variable in the long run.
C.
1.
For example, in the long run a firm could choose the size of its factory.
2.
Once a factory is chosen, the firm must deal with the short-run costs associated
with that plant size.
The long-run average-total-cost curve lies along the lowest points of the short-run
average-total-cost curves because the firm has more flexibility in the long run to deal
with changes in production.
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Figure 6
D.
The long-run average-total-cost curve is typically U-shaped, but is much flatter than a
typical short-run average-total-cost curve.
E.
The length of time for a firm to get to the long run will depend on the firm involved.
F.
Economies and Diseconomies of Scale
1.
Definition of economies of scale: the property whereby long-run average
total cost falls as the quantity of output increases.
2.
Definition of diseconomies of scale: the property whereby long-run
average total cost rises as the quantity of output increases.
3.
Definition of constant returns to scale: the property whereby long-run
average total cost stays the same as the quantity of output changes.
254 ) Chapter 13/The Costs of Production
4.
V.
FYI: Lessons from a Pin Factory
a.
In The Wealth of Nations, Adam Smith described how specialization in a
pin factory allowed output to be greater than it would have been if each
worker attempted to perform many different tasks.
b.
The use of specialization allows firms to achieve economies of scale.
Table 3 provides a summary of all of the various cost definitions used throughout this chapter.
Table 3
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
2.
Farmer McDonald’s opportunity cost is $300, consisting of 10 hours of lessons at $20 an hour
that he could have been earning plus $100 in seeds. His accountant would only count the
explicit cost of the seeds ($100). If McDonald earns $200 from selling the crops, then McDonald
earns a $100 accounting profit ($200 sales minus $100 cost of seeds) but makes an economic
loss of $100 ($200 sales minus $300 opportunity cost).
PMG
Farmer Jones’s production function is shown in Figure 1 and his total-cost curve is shown in
Figure 2. The production function becomes flatter as the number of bags of seeds increases
because of the diminishing marginal product of seeds. The total-cost curve gets steeper as the
amount of production increases. This feature is also due to the diminishing marginal product of
seeds, since each additional bag of seeds generates a lower marginal product, and thus, the cost
of producing additional bushels of wheat rises.
Figure 1
Figure 2
Chapter 13/The Costs of Production ) 255
3.
The average total cost of producing 5 cars is $250,000 / 5 = $50,000. Since total cost rose from
$225,000 to $250,000 when output increased from 4 to 5, the marginal cost of the fifth car is
$25,000.
The marginal-cost curve and the average-total-cost curve for a typical firm are shown in Figure 3.
They cross at the efficient scale because at low levels of output, marginal cost is below average
total cost, so average total cost is falling. But after the two curves cross, marginal cost rises
above average total cost, and average total cost starts to rise. So the point of intersection must
be the minimum of average total cost.
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Figure 3
4.
The long-run average total cost of producing 9 planes is $9 million / 9 = $1 million. The long-run
average total cost of producing 10 planes is $9.5 million / 10 = $0.95 million. Since the long-run
average total cost declines as the number of planes increases, Boeing exhibits economies of
scale.
Questions for Review
1.
The relationship between a firm's total revenue, profit, and total cost is profit equals total
revenue minus total costs.
2.
An accountant would not count the owner’s opportunity cost of alternative employment as an
accounting cost. An example is given in the text in which Helen runs a cookie business, but she
could instead work as a computer programmer. Because she's working in her cookie factory, she
gives up the opportunity to earn $100 per hour as a computer programmer. The accountant
ignores this opportunity cost because money does not flow into or out of the firm. But the cost is
relevant to Helen's decision to run the cookie factory.
3.
Marginal product is the increase in output that arises from an additional unit of input. Diminishing
marginal product means that the marginal product of an input declines as the quantity of the
input increases.
256 ) Chapter 13/The Costs of Production
4.
Figure 4 shows a production function that exhibits diminishing marginal product of labor. Figure 5
shows the associated total-cost curve. The production function is concave because of diminishing
marginal product, while the total-cost curve is convex for the same reason.
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Figure 4
5.
Figure 5
Total cost consists of the costs of all inputs needed to produce a given quantity of output. It
includes fixed costs and variable costs. Average total cost is the cost of a typical unit of output
and is equal to total cost divided by the quantity produced. Marginal cost is the cost of producing
an additional unit of output and is equal to the change in total cost divided by the change in
quantity. An additional relation between average total cost and marginal cost is that whenever
marginal cost is less than average total cost, average total cost is declining; whenever marginal
cost is greater than average total cost, average total cost is rising.
Figure 6
6.
Figure 6 shows the marginal-cost curve and the average-total-cost curve for a typical firm. It has
three main features: (1) marginal cost is rising; (2) average total cost is U-shaped; and (3)
Chapter 13/The Costs of Production ) 257
whenever marginal cost is less than average total cost, average total cost is declining; whenever
marginal cost is greater than average total cost, average total cost is rising. Marginal cost is
rising for output greater than a certain quantity because of diminishing returns. The averagetotal-cost curve is U-shaped because the firm initially is able to spread out fixed costs over
additional units, but as quantity increases, it costs more to increase quantity further because an
important input is limited. Whenever marginal cost is less than average total cost, average total
cost is declining; whenever marginal cost is greater than average total cost, average total cost is
rising. The marginal cost and average total cost curves intersect at the minimum of average total
cost; that quantity is the efficient scale.
7.
In the long run, a firm can adjust the factors of production that are fixed in the short run; for
example, it can increase the size of its factory. As a result, the long-run average-total-cost curve
has a much flatter U-shape than the short-run average-total-cost curve. In addition, the long-run
curve lies along the lower envelope of the short-run curves.
8.
Economies of scale exist when long-run average total cost falls as the quantity of output
increases, which occurs because of specialization among workers. Diseconomies of scale exist
when long-run average total cost rises as the quantity of output increases, which occurs because
of coordination problems inherent in a large organization.
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Problems and Applications
1.
2.
3.
4.
a. opportunity cost; b. average total cost; c. fixed cost; d. variable cost; e. total cost;
f. marginal cost.
a.
The opportunity cost of something is what must be given up to acquire it.
b.
The opportunity cost of running the hardware store is $550,000, consisting of $500,000
to rent the store and buy the stock and a $50,000 opportunity cost, because your aunt
would quit her job as an accountant to run the store. Because the total opportunity cost
of $550,000 exceeds revenue of $510,000, your aunt should not open the store, as her
profit would be negative.
a.
Because you would have to pay for room and board whether you went to college or not,
that portion of your college payment is not an opportunity cost.
b.
The explicit opportunity cost of attending college is the cost of tuition and books.
c.
An implicit opportunity cost of attending college is the cost of your time. You could work
at a job for pay rather than attend college. The wages you give up represent an
opportunity cost of attending college.
a.
The following table shows the marginal product of each hour spent fishing:
Hours
0
1
2
3
4
5
Fish
0
10
18
24
28
30
Fixed Cost
$10
10
10
10
10
10
Variable Cost
$0
5
10
15
20
25
Total Cost
$10
15
20
25
30
25
Marginal Product
--10
8
6
4
2
258 ) Chapter 13/The Costs of Production
b.
Figure 7 graphs the fisherman's production function. The production function becomes
flatter as the number of hours spent fishing increases, illustrating diminishing marginal
product.
Figure 7
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c.
The table shows the fixed cost, variable cost, and total cost of fishing. Figure 8 shows
the fisherman's total-cost curve. It has an upward slope because catching additional fish
takes additional time. The curve is convex because there are diminishing returns to
fishing time because each additional hour spent fishing yields fewer additional fish.
Figure 8
Chapter 13/The Costs of Production ) 259
5.
Here is the table of costs:
Workers
Output
0
1
2
3
4
5
6
7
0
20
50
90
120
140
150
155
Marginal
Product
--20
30
40
30
20
10
5
Total
Cost
$200
300
400
500
600
700
800
900
Average
Total Cost
--$15.00
8.00
5.56
5.00
5.00
5.33
5.81
Marginal
Cost
--$5.00
3.33
2.50
3.33
5.00
10.00
20.00
a.
See the table for marginal product. Marginal product rises at first, then declines because
of diminishing marginal product.
b.
See the table for total cost.
c.
See the table for average total cost. Average total cost is U-shaped. When quantity is
low, average total cost declines as quantity rises; when quantity is high, average total
cost rises as quantity rises.
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6.
d.
See the table for marginal cost. Marginal cost is also U-shaped, but rises steeply as
output increases. This is due to diminishing marginal product.
e.
When marginal product is rising, marginal cost is falling, and vice versa.
f.
When marginal cost is less than average total cost, average total cost is falling; the cost
of the last unit produced pulls the average down. When marginal cost is greater than
average total cost, average total cost is rising; the cost of the last unit produced pushes
the average up.
a.
The fixed cost is $300, because fixed cost equals total cost minus variable cost.
b.
Quantity
0
1
2
3
4
5
6
Total
Cost
$300
350
390
420
450
490
540
Variable
Cost
$0
50
90
120
150
190
240
Marginal Cost
(using total cost)
--$50
40
30
30
40
50
Marginal Cost
(using variable cost)
--$50
40
30
30
40
50
Marginal cost equals the change in total cost for each additional unit of output. It is also
equal to the change in variable cost for each additional unit of output. This occurs
because total cost equals the sum of variable cost and fixed cost and fixed cost does not
change as the quantity changes. Thus, as quantity increases, the increase in total cost
equals the increase in variable cost.
260 ) Chapter 13/The Costs of Production
7.
a.
The fixed cost of setting up the lemonade stand is $200. The variable cost per cup is
$0.50.
Figure 9
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b.
The following table shows total cost, average total cost, and marginal cost. These are
plotted in Figure 9.
Quantity
(gallons)
0
1
2
3
4
5
6
7
8
9
10
Total Cost
Average Total Cost
Marginal Cost
$200
208
216
224
232
240
248
256
264
272
280
--$208
108
74.7
58
48
41.3
36.6
33
30.2
28
--$8
8
8
8
8
8
8
8
8
8
Chapter 13/The Costs of Production ) 261
8.
The following table illustrates average fixed cost (AFC), average variable cost (AVC), and average
total cost (ATC) for each quantity. The efficient scale is four houses per month, because that
minimizes average total cost.
Quantity
0
1
2
3
4
5
6
7
9.
a.
Variable
Cost
$0
10
20
40
80
160
320
640
Fixed
Cost
$200
200
200
200
200
200
200
200
Total
Cost
$200
210
220
240
280
360
520
840
Average
Fixed Cost
--$200
100
66.7
50
40
33.3
28.6
Average
Variable Cost
--$10
10
13.3
20
32
53.3
91.4
Average
Total Cost
--$210
110
80
70
72
86.7
120
The following table shows average variable cost (AVC), average total cost (ATC), and
marginal cost (MC) for each quantity.
Quantity
0
1
2
3
4
5
6
Variable
Cost
$0
10
25
45
70
100
135
Total
Cost
$30
40
55
75
100
130
165
Average
Variable Cost
--$10
12.5
15
17.5
20
22.5
Average
Total Cost
--$40
27.5
25
25
26
27.5
Marginal
Cost
--$10
15
20
25
30
35
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b.
Figure 10 shows the three curves. The marginal-cost curve is below the average-totalcost curve when output is less than four and average total cost is declining. The
marginal-cost curve is above the average-total-cost curve when output is above four and
average total cost is rising. The marginal-cost curve lies above the average-variable-cost
curve.
Figure 10
262 ) Chapter 13/The Costs of Production
10.
a.
The following table shows the firm’s fixed cost (FC), variable cost (VC), and total cost
(TC):
Quantity
0
1
2
3
4
5
6
7
8
9
10
b.
Fixed Cost
$100
100
100
100
100
100
100
100
100
100
100
Variable Cost
$0
5
10
15
20
25
30
35
40
45
50
Total Cost
$100
105
110
115
120
125
130
135
140
145
150
The following table shows the firm’s marginal cost (MC) and average total cost (ATC):
Quantity
0
1
2
3
4
5
6
7
8
9
10
Marginal Cost
---5
5
5
5
5
5
5
5
5
5
Average Total Cost
---105
55
38.33
30
25
21.67
19.29
17.50
16.11
15
PMG
The marginal-cost and average-total-cost curves are shown in Figure 11.
Costs
100
80
60
40
20
1 2 3 4 5 6 7 8 9 10
Quantity
of Output
Figure 11
c.
The firm’s marginal cost is $5 for every unit produced. This implies that the production
function does not face diminishing marginal returns.
Chapter 13/The Costs of Production ) 263
11.
The following table shows quantity (Q), total cost (TC), and average total cost (ATC) for the
three firms:
Firm A
Quantity
1
2
3
4
5
6
7
Firm B
Firm C
TC
ATC
TC
ATC
TC
ATC
60
70
80
90
100
110
120
60
35
26.7
22.5
20
18.3
17.1
11
24
39
56
75
96
119
11
12
13
14
15
16
17
21
34
49
66
85
106
129
21
17
16.3
16.5
17
17.7
18.4
Firm A has economies of scale because average total cost declines as output increases. Firm B
has diseconomies of scale because average total cost rises as output rises. Firm C has economies
of scale for output from one to three and diseconomies of scale for levels of output beyond three
units.
PMG
PMG
14
FIRMS IN COMPETITIVE
MARKETS
WHAT’S NEW IN THE FOURTH EDITION:
The rules for profit maximization are written more clearly.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
¾
what characteristics make a market competitive.
¾
how competitive firms decide how much output to produce.
¾
how competitive firms decide when to shut down production temporarily.
¾
how competitive firms decide whether to exit or enter a market.
¾
how firm behavior determines a market’s short-run and long-run supply curves.
PMG
CONTEXT AND PURPOSE:
Chapter 14 is the second chapter in a five-chapter sequence dealing with firm behavior and the
organization of industry. Chapter 13 developed the cost curves on which firm behavior is based. These
cost curves are employed in Chapter 14 to show how a competitive firm responds to changes in market
conditions. Chapters 15 through 17 will employ these cost curves to see how firms with market power
(monopolistic, oligopolistic, and monopolistically competitive firms) respond to changes in market
conditions.
The purpose of Chapter 14 is to examine the behavior of competitive firms—firms that do not
have market power. The cost curves developed in the previous chapter shed light on the decisions that
lie behind the supply curve in a competitive market.
KEY POINTS:
1. Because a competitive firm is a price taker, its revenue is proportional to the amount of output it
produces. The price of the good equals both the firm’s average revenue and its marginal revenue.
265
266 ) Chapter 14/Firms in Competitive Markets
2. To maximize profit, a firm chooses a quantity of output such that marginal revenue equals marginal
cost. Because marginal revenue for a competitive firm equals the market price, the firm chooses
quantity so that price equals marginal cost. Thus, the firm’s marginal cost curve is its supply curve.
3. In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down
temporarily if the price of the good is less than average variable cost. In the long run, when the firm
can recover both fixed and variable costs, it will choose to exit if the price is less than average total
cost.
4. In a market with free entry and exit, profits are driven to zero in the long run. In this long-run
equilibrium, all firms produce at the efficient scale, price equals minimum average total cost, and the
number of firms adjusts to satisfy the quantity demanded at this price.
5. Changes in demand have different effects over different time horizons. In the short run, an increase
in demand raises prices and leads to profits, and a decrease in demand lowers prices and leads to
losses. But if firms can freely enter and exit the market, then in the long run the number of firms
adjusts to drive the market back to the zero-profit equilibrium.
CHAPTER OUTLINE:
I.
PMG
What Is a Competitive Market?
A.
The Meaning of Competition
Remember that students have a difficult time understanding what a competitive
market is. The use of the word “competition” in economics is much different from
that in sports. This will lead students to often forget that these firms are generally
unconcerned with the actions of their rivals.
1.
Definition of competitive market: a market with many buyers and sellers
trading identical products so that each buyer and seller is a price taker.
2.
There are three characteristics of a competitive market (sometimes called a
perfectly competitive market).
a.
There are many buyers and sellers.
b.
The goods offered by the sellers are largely the same.
c.
Firms can freely enter or exit the market.
To help students understand price-taking behavior, use the example of common
stock. Have your students assume that they inherited 100 shares of stock in a wellknown company. Point out that these 100 shares may seem like a lot, but it is a very
small proportion of the total number of shares outstanding. If the student wanted to
know the value of a share, it could be obtained from a broker. At this marketdetermined price, the student could sell as few or as many shares as he or she
wishes. At a price above this, no one would be willing to buy any. There is also no
reason to charge a price below the current market price, because the student can sell
any number of shares that he or she wishes at the current price.
Chapter 14/Firms in Competitive Markets ) 267
B.
The Revenue of a Competitive Firm
Table 1
1.
Total revenue from the sale of output is equal to price times quantity.
Total Revenue = Price × Quantity
Make sure that students realize that firms in perfect competition can only change
their level of total revenue by varying their level of output because they have no
ability to change the price.
2.
Definition of average revenue: total revenue divided by the quantity
sold.
Average Revenue =
Total Revenue
Quantity
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3.
Definition of marginal revenue: the change in total revenue from an
additional unit sold.
Marginal Revenue =
change in Total Revenue
change in Quantity
You may want to make it clear that, by definition, average revenue is always equal to
price. But marginal revenue is equal to price only for firms that operate in perfectly
competitive markets.
II.
Profit Maximization and the Competitive Firm's Supply Curve
Table 2
A.
A Simple Example of Profit Maximization: The Smith Dairy Farm
Q
Total
Revenue
Total
Cost
Profit
Marginal
Revenue
Marginal
Cost
Change in
Profit
0
$0
$3
$-3
----
----
----
1
6
5
1
$6
$2
$4
2
12
8
4
6
3
3
3
18
12
6
6
4
2
4
24
17
7
6
5
1
5
30
23
7
6
6
0
6
36
30
6
6
7
-1
7
42
38
4
6
8
-2
8
48
47
1
6
9
-3
268 ) Chapter 14/Firms in Competitive Markets
1.
In this example, profit is maximized if the farm produces four or five gallons of
milk (see the fourth column).
2.
The profit-maximizing quantity can also be found by comparing marginal revenue
and marginal cost.
a.
As long as marginal revenue exceeds marginal cost, increasing output
will raise profit.
b.
If marginal revenue is less than marginal cost, the firm can increase
profit by decreasing output.
c.
Profit-maximization occurs where marginal revenue is equal to marginal
cost.
ALTERNATIVE CLASSROOM EXAMPLE:
Polly’s Ping Pong Balls is a firm that operates in a competitive market. The ping pong balls
sell for $3 per package. Fill in the following table with the class's help and discuss the profitmaximizing level of output:
Output
Price
Total
Revenue
$0.00
3.00
6.00
9.00
12.00
15.00
18.00
21.00
24.00
27.00
Total
Cost
$1.50
2.00
3.00
4.50
6.50
9.00
12.00
15.50
19.50
24.00
Profit
Marginal
Revenue
---$3
3
3
3
3
3
3
3
3
Marginal
Cost
---$0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
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0
1
2
3
4
5
6
7
8
9
B.
$3
3
3
3
3
3
3
3
3
3
$-1.50
1.00
3.00
4.50
5.50
6.00
6.00
5.50
4.50
3.00
The Marginal-Cost Curve and the Firm's Supply Decision
Figure 1
The graphs in this chapter often confuse students because they contain many
different curves at the same time. Thus, the first time you draw the profit-maximizing
decision of the firm, use only the marginal cost curve and the marginal revenue line.
Then, after students feel comfortable with this, add average total cost (to teach
students how to measure profit or loss). Last, add average variable cost to teach
students about the short-run shutdown decision of a firm earning an economic loss.
Point out that each of the short-run cost curves tell a different part of the story.
1.
Cost curves have special features that are important for our analysis.
a.
The marginal-cost curve is upward sloping.
Chapter 14/Firms in Competitive Markets ) 269
b.
The average-total-cost curve is U-shaped.
c.
The marginal-cost curve crosses the average-total-cost curve at the
minimum of average total cost.
2.
Marginal and average revenue can be shown by a horizontal line at the market
price.
3.
To find the profit-maximizing level of output, we can follow the same rules that
we discussed above.
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4.
a.
If marginal revenue is greater than the marginal cost, the firm should
increase its output.
b.
If marginal cost is greater than marginal revenue, the firm should
decrease its output.
c.
At the profit-maximizing level of output, marginal revenue and marginal
cost are exactly equal.
These rules apply not only to competitive firms, but to firms with market power
as well.
270 ) Chapter 14/Firms in Competitive Markets
Activity 1—A Profitable Opportunity?
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
Profit maximization
None
15 minutes
Works in any size class
Purpose
This exercise reinforces the importance of marginal cost in decisionmaking. It shows average
costs can be misleading.
Instructions
Tell the class, “As a recent graduate of this college you have landed a job in production
management for Universal Clones, Inc. You are responsible for the entire company on
weekends.”
“Your costs are shown below.”
Quantity
500
501
Average Total Cost
200
201
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Your current level of production is 500 units. All 500 units have been ordered by your regular
customers.
“The phone rings. It’s a new customer who wants to buy one unit of your product. This
means you would have to increase production to 501 units. Your new customer offers you
$450 to produce the extra unit.”
a. Should you accept this offer?
b. What is the net change in the firm’s profit?
Common Answers and Points for Discussion
Most students will answer “yes.” Selling something for $450 when the average cost of
production is $201 seems like good business. They are wrong.
The relevant comparison is marginal cost to marginal revenue. Marginal cost can be easily
calculated as the change in total costs.
Quantity
500
501
Average Total Cost
200
201
Total Cost = Q × ATC
100,000
100,701
$100,701 – $100,000 = $701
Marginal cost in this example is $701. This is much higher than the marginal revenue of $450.
The offer should not be accepted. It would result in a $251 loss.
Chapter 14/Firms in Competitive Markets ) 271
Figure 2
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C.
5.
If the price in the market were to change to P2, the firm would set its new level
of output by equating marginal revenue and marginal cost.
6.
Because the firm's marginal cost curve determines how much the firm is willing
to supply at any price, it is the competitive firm's supply curve.
The Firm's Short-Run Decision to Shut Down
1.
In certain circumstances, a firm will decide to shut down and produce zero
output.
2.
There is a difference between a temporary shutdown of a firm and an exit from
the market.
a.
A shutdown refers to a short-run decision not to produce anything during
a specific period of time because of current market conditions.
b.
Exit refers to a long-run decision to leave the market.
c.
One important difference is that, when a firm shuts down temporarily, it
still must pay fixed costs. If a firm exits the industry in the long run, it
has no costs.
3.
If a firm shuts down, it will earn no revenue and will have only fixed costs (no
variable costs).
4.
Therefore, a firm will shut down if the revenue that it would get from producing
is less than its variable costs of production:
Shut down if TR < VC.
272 ) Chapter 14/Firms in Competitive Markets
5.
Because TR = P x Q and VC = AVC x Q, we can rewrite this condition as:
Shut down if P < AVC.
6.
We now can tell exactly what the firm will do to maximize profit (or minimize
loss).
a.
If the price is less than average variable cost, the firm will produce no
output.
b.
If the price is above average variable cost, the firm will produce the level
of output where marginal revenue (price) is equal to marginal cost.
If:
P ≥ AVC
P < AVC
7.
The Firm Will:
Produce output level where MR = MC
Shut down and produce zero output
Therefore, the competitive firm's short-run supply curve is the portion of its
marginal revenue curve that lies above average variable cost.
Figure 3
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Price and
Cost
Marginal Cost
ATC
AVC
Firm’s Short-Run
Supply Curve
Quantity
8.
9.
Spilt Milk and Other Sunk Costs
a.
Definition of sunk cost: a cost that has been committed and
cannot be recovered.
b.
Once a cost is sunk, it is no longer an opportunity cost.
c.
Because nothing can be done about sunk costs, you should ignore them
when making decisions.
Case Study: Near-Empty Restaurants and Off-Season Miniature Golf
a.
In making a decision of whether or not to open for lunch, a restaurant
owner must weigh revenue with variable costs. (Much of the cost of
running a restaurant is somewhat fixed.)
Chapter 14/Firms in Competitive Markets ) 273
b.
D.
The same criteria would apply to a decision of whether a miniature golf
course in a summer resort community should stay open during other
seasons. The course should only be open if revenue exceeds variable
costs.
The Firm's Long-Run Decision to Exit or Enter a Market
1.
If a firm exits the market, it will earn no revenue, but it will have no costs as
well.
2.
Therefore, a firm will exit if the revenue that it would earn from producing is less
than its total costs:
Exit if TR < TC.
3.
Because TR = P x Q and TC = ATC x Q, we can rewrite this condition as:
Exit if P < ATC.
4.
A firm will enter an industry when there is profit potential, so this must mean
that a firm will enter if revenues will exceed costs:
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Enter if P > ATC.
Figure 4
5.
Because, in the long run, a firm will remain in a market only if P ≥ ATC, the
firm's long-run supply curve will be its marginal cost curve above ATC.
If:
P > ATC
P = ATC
P < ATC
E.
The Firm Will:
Enter because economic profits are earned
Not enter or exit because economic profits are zero
Exit because economic losses are incurred
Measuring Profit in Our Graph for the Competitive Firm
274 ) Chapter 14/Firms in Competitive Markets
1.
Recall that Profit = TR −TC.
2.
Because TR = P x Q and TC = ATC x Q, we can rewrite this equation:
Profit = (P – ATC) x Q.
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3.
Using this equation, we can measure the amount of profit (or loss) at the firm's
profit-maximizing level of output (or loss-minimizing level of output).
Students always want to use the point of minimum average total cost when finding
profit on the graph. Remind them to always find the average total cost of the profitmaximizing level of output.
Figure 5
Chapter 14/Firms in Competitive Markets ) 275
Keep reminding students that economic profits and losses are different from
accounting profits and losses. Point out that economic cost includes the cost of all
resources, including a “normal return or profit” to compensate the firm’s owner for
the risks and other efforts put into the business.
III.
The Supply Curve in a Competitive Market
A.
The Short Run: Market Supply with a Fixed Number of Firms
Figure 6
B.
1.
Example: a market with 1,000 identical firms.
2.
Each firm's short-run supply curve is its marginal cost curve above average
variable cost.
3.
To get the market supply curve, we add the quantity supplied by each firm in the
market at every given price.
The Long Run: Market Supply with Entry and Exit
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Figure 7
1.
2.
If firms in an industry are earning profit, this will attract new firms.
a.
The supply of the product will increase (the supply curve will shift to the
right).
b.
The price of the product will fall and profit will decline.
If firms in an industry are incurring losses, firms will exit.
a.
The supply of the product will decrease (the supply curve will shift to the
left).
b.
The price of the product will rise and losses will decline.
3.
At the end of this process of entry or exit, firms that remain in the market must
be earning zero economic profit.
4.
Because Profit = TR –TC, profit will only be zero when:
TR = TC.
5.
Because TR = P x Q and TC = ATC x Q, we can rewrite this as:
P = ATC.
6.
Therefore, the process of entry or exit ends only when price and average total
cost become equal.
7.
This implies that the long-run equilibrium of a competitive market must have
firms operating at their efficient scale.
276 ) Chapter 14/Firms in Competitive Markets
C.
D.
Why Do Competitive Firms Stay in Business If They Make Zero Profit?
1.
Profit is equal to total revenue minus total cost.
2.
To an economist, total cost includes all of the opportunity costs of the firm.
3.
When a firm is earning zero profit, this must mean that the firm's revenues are
compensating the firm's owners for the time and money that they have
expended to keep their businesses going.
A Shift in Demand in the Short Run and Long Run
1.
Assume that the market begins in long-run equilibrium. This means that firms
are earning zero profit and price equals the minimum of average total cost.
2.
If the demand for the product increases, this will lead to an increase in the price
of the good.
3.
Firms will respond to the increase in price by producing more in the short run.
4.
Because price is now greater than average total cost, firms are earning profit.
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Figure 8
5.
The profit will attract new firms into the industry, shifting the supply curve to the
right.
6.
This will lower price until it falls back to the minimum of average total cost and
firms are once again earning zero economic profit.
Chapter 14/Firms in Competitive Markets ) 277
After going through the effects of an increase in demand, ask students to work
through the effects of a decrease in demand with you. Make sure that they can see
that firms would exit the market because of economic losses.
E.
Why the Long-Run Supply Curve Might Slope Upward
1.
Because we assumed that all potential entrants faced the same costs as existing
firms, average total cost of each firm was unaffected by the entry of new firms
into the industry.
2.
In this situation, the long-run supply of the industry will be a horizontal line at
minimum average total cost.
3.
However, there are two possible reasons why this may not be the case.
a.
If a resource is limited in quantity, entry of firms will increase the price
of this resource, raising the average total cost of production.
b.
If firms have different costs, then it is likely that those with the lowest
costs will enter the industry first. If the demand for the product then
increases, the firms that would enter will likely have higher costs than
those firms already in the market.
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4.
In this situation, the long-run supply curve of the industry will be upward
sloping.
No matter what the shape of the long-run supply curve, an increase in demand will
always lead to a rise in the price in the short run and a decrease in demand will
always lead to a drop in price in the short run. Long-run supply curves will always be
more elastic than short-run supply curves.
5.
In either case, the long-run supply curve of an industry is generally more elastic
than the short-run supply curve of the industry (because firms can enter or exit
in the long run).
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
When a competitive firm doubles the amount it sells, the price remains the same, so its total
revenue doubles.
2.
The price faced by a profit-maximizing competitive firm is equal to its marginal cost because if
278 ) Chapter 14/Firms in Competitive Markets
price were above marginal cost, the firm could increase profits by increasing output, while if price
were below marginal cost, the firm could increase profits by decreasing output.
A profit-maximizing competitive firm decides to shut down in the short run when price is less
than average variable cost. In the long run, a firm will exit a market when price is less than
average total cost.
3.
In the long run, with free entry and exit, the price in the market is equal to both a firm’s marginal
cost and its average total cost, as Figure 1 shows. The firm chooses its quantity so that marginal
cost equals price; doing so ensures that the firm is maximizing its profit. In the long run, entry
into and exit from the industry drive the price of the good to the minimum point on the averagetotal-cost curve.
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Figure 1
Questions for Review
1.
A competitive firm is a firm in a market in which: (1) there are many buyers and many sellers in
the market; (2) the goods offered by the various sellers are largely the same; and (3) usually
firms can freely enter or exit the market.
Chapter 14/Firms in Competitive Markets ) 279
2.
Figure 2 shows the cost curves for a typical firm. For a given price (such as P*), the level of
output that maximizes profit is the output where marginal cost equals price (Q*), as long as price
exceeds average variable cost at that point (in the short run), or exceeds average total cost (in
the long run).
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Figure 2
3.
4.
5.
A firm will shut down temporarily if the revenue it would get from producing is lower than the
variable costs of production. This occurs if price is less than average variable cost.
A firm will exit a market if the revenue it would get from remaining in business is less than its
total cost. This occurs if price is less than average total cost.
A firm's price equals marginal cost in both the short run and the long run. In both the short run
and the long run, price equals marginal revenue. The firm should increase output as long as
marginal revenue exceeds marginal cost, and reduce output if marginal revenue is less than
marginal cost. Profits are always maximized when marginal revenue equals marginal cost.
6.
The firm's price must equal the minimum of average total cost only in the long run. In the short
run, price may be greater than average total cost (in which case the firm is making profits), price
may be less than average total cost (in which case the firm is making losses), or price may be
equal to average total cost (in which case the firm is breaking even). In the long run, if firms are
making profits, other firms will enter the industry, which will lower the price of the good. In the
long run, if firms are making losses, they will exit the industry, which will raise the price of the
good. Entry or exit continues until firms are making neither profits nor losses. At that point, price
equals average total cost.
7.
Market supply curves are typically more elastic in the long run than in the short run. In a
competitive market, because entry or exit occurs until price equals average total cost, quantity
supplied is more responsive to changes in price in the long run.
Problems and Applications
1.
Because a new customer is offering to pay $300 for one dose, the marginal revenue of the 201st
dose is $300. Now we must find out if marginal cost is greater than or less than $300. To do this,
we need to calculate total cost for 200 doses and 201 doses, and then calculate the increase in
280 ) Chapter 14/Firms in Competitive Markets
total cost. Multiplying quantity by average total cost, we find that total cost rises from $40,000 to
$40,401, so marginal cost is $401. Therefore, your roommate should not make the additional
dose.
2.
The rise in the price of crude oil increases production costs for individual firms and thus shifts the
industry supply curve up, as shown in Figure 3. The typical firm's initial marginal-cost curve is
MC1 and its average-total-cost curve is ATC1. In the initial equilibrium, the industry supply curve,
S1, intersects the demand curve at price P1, which is equal to the minimum average total cost of
the typical firm. Thus, the typical firm earns no economic profit.
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Figure 3
The increase in the price of oil shifts the typical firm's cost curves up to MC2 and ATC2, and shifts
the industry supply curve up to S2. The equilibrium price rises from P1 to P2, but the price does
not increase by as much as the increase in marginal cost for the firm. As a result, price is less
than average total cost for the firm, so profits are negative.
In the long run, the negative profits lead some firms to exit the industry. As they do so, the
industry-supply curve shifts to the left. This continues until the price rises to equal the minimum
point on the firm's average-total-cost curve. The long-run equilibrium occurs with supply curve
S3, equilibrium price P3, industry output Q3, and firm's output q3. Thus, in the long run, profits are
zero again and there are fewer firms in the industry.
3.
Once you have ordered the dinner, its cost is sunk, so it does not represent an opportunity cost.
As a result, the cost of the dinner should not influence your decision about whether to finish it or
not.
4.
Because Bob’s average total cost is $280/10 = $28, which is greater than the price, he will exit
the industry in the long run. Because fixed cost is $30, average variable cost is ($280 − $30)/10
= $25, which is less than price, so Bob will not shut down in the short run.
Chapter 14/Firms in Competitive Markets ) 281
5.
Here is the table showing costs, revenues, and profits:
Quantity
0
1
2
3
4
5
6
7
Total
Cost
$8
9
10
11
13
19
27
37
Marginal
Cost
--$1
1
1
2
6
8
10
Total
Revenue
$0
8
16
24
32
40
48
56
Marginal
Revenue
--$8
8
8
8
8
8
8
Profit
$-8
-1
6
13
19
21
21
19
a.
The firm should produce five or six units to maximize profit.
b.
Marginal revenue and marginal cost are graphed in Figure 4. The curves cross at a
quantity between five and six units, yielding the same answer as in Part (a).
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Figure 4
c.
This industry is competitive because marginal revenue is the same for each quantity.
The industry is not in long-run equilibrium, because profit is not equal to zero.
282 ) Chapter 14/Firms in Competitive Markets
6.
a.
Figure 5 shows the short-run effect of declining demand for beef. The shift of the
industry demand curve from D1 to D2 reduces the quantity from Q1 to Q2 and reduces the
price from P1 to P2. This affects the firm, reducing its quantity from q1 to q2. Before the
decline in the price, the firm was making zero profits; afterwards, profits are negative, as
average total cost exceeds price.
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Figure 5
b.
Figure 6 shows the long-run effect of declining demand for beef. Because firms were
losing money in the short run, some firms leave the industry. This shifts the supply curve
from S1 to S3. The shift of the supply curve is just enough to increase the price back to
its original level, P1. As a result, industry output falls to Q3. For firms that remain in the
industry, the rise in the price to P1 returns them to their original situation, producing an
output level of q1 and earning zero profits.
Figure 6
Chapter 14/Firms in Competitive Markets ) 283
7.
a.
Figure 7 shows the typical firm in the industry, with average total cost ATC1, marginal
cost MC1, and price P1.
b.
The new process reduces Hi-Tech’s marginal cost to MC2 and its average total cost to
ATC2, but the price remains at P1 because other firms cannot use the new process. Thus
Hi-Tech earns positive profits.
c.
When the patent expires and other firms are free to use the technology, all firms’
average-total-cost curves decline to ATC2, so the market price falls to P3 and firms earn
zero profit.
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Figure 7
8.
a.
If firms are currently incurring losses, price must be less than average total cost.
However, because firms in the industry are currently producing output, price must be
greater than average variable cost. If firms are maximizing profits, price must be equal to
marginal cost.
284 ) Chapter 14/Firms in Competitive Markets
b.
The present situation is depicted in Figure 8. The firm is currently producing q1 units of
output at a price of P1.
MC
Price
and
Costs
P2
S2
Price
and
ATC Costs
S1
AVC
P1
D
q1 q2
Quantity
Q2
Q1
Quantity
Figure 8
c.
9.
Figure 8 also shows how the market will adjust in the long run. Because firms are
incurring losses, there will be exit in this industry. This means that the market supply
curve will shift to the left, increasing the price of the product. As the price rises, the
remaining firms will increase quantity supplied. Exit will continue until price is equal to
minimum average total cost. Average total cost will be lower in the long run than in the
short run. The total quantity supplied in the market will fall.
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a.
Figure 9 illustrates the situation in the U.S. textile industry. With no international trade,
the market is in long-run equilibrium. Supply intersects demand at quantity Q1 and price
$30, with a typical firm producing output q1.
Figure 9
b.
The effect of imports at $25 is that the market supply curve follows the old supply curve
up to a price of $25, then becomes horizontal at that price. As a result, demand exceeds
domestic supply, so the country imports textiles from other countries. The typical
Chapter 14/Firms in Competitive Markets ) 285
domestic firm now reduces its output from q1 to q2, incurring losses, because the large
fixed costs imply that average total cost will be much higher than the price.
10.
c.
In the long run, domestic firms will be unable to compete with foreign firms because
their costs are too high. All the domestic firms will exit the industry and other countries
will supply enough to satisfy the entire domestic demand.
a.
The firms' variable cost (VC), total cost (TC), marginal cost (MC), and average total cost
(ATC) are shown in the table below:
Quantity
1
2
3
4
5
6
b.
VC
1
4
9
16
25
36
TC
17
21
26
32
41
52
MC
1
3
5
7
9
11
ATC
17
10.50
8.67
8
8.20
8.67
If the price is $10, each firm will produce five units, so there will be 5 × 100 = 500 units
supplied in the market.
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c.
At a price of $10 and a quantity supplied of five, each firm is earning a positive profit
because price is greater than average total cost. Thus, entry will occur and the price will
fall. As price falls, quantity demanded will rise and the quantity supplied by each firm will
fall.
d.
Figure 10 shows the long-run industry supply curve, which will be horizontal at minimum
average total cost.
Firm
Price
and
Costs
Industry
MC
Price
and
ATC Costs
P1
S
Quantity
Figure 10
Quantity
286 ) Chapter 14/Firms in Competitive Markets
11.
a.
Figure 11 shows the current equilibrium in the market for pretzels. The supply curve, S1,
intersects the demand curve at price P1. Each stand produces quantity q1 of pretzels, so
the total number of pretzels produced is 1,000 × q1. Stands earn zero profit, because
price is equal to average total cost.
Figure 11
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12.
b.
If the city government restricts the number of pretzel stands to 800, the industry-supply
curve shifts to S2. The market price rises to P2, and individual firms produce output q2.
Industry output is now 800 × q2. Now the price exceeds average total cost, so each firm
is making a positive profit. Without restrictions on the market, this would induce other
firms to enter the market, but they cannot because the government has limited the
number of licenses.
c.
If the city charges a license fee for the licenses, it will have no effect on marginal cost,
so it will not affect the firm's output. It will, however, reduce the firm's profits. As long as
the firm is left with a zero or positive profit, it will continue to operate. Thus, as long as
the industry supply curve is unaffected, the price of pretzels will not change.
d.
The license fee that brings the most money to the city is equal to (P2 - ATC2)q2, which is
the amount of each firm's profit.
a.
Figure 12 illustrates the gold-mining industry and a representative gold mine (firm). The
demand curve, D1, intersects the supply curve at industry quantity Q1 and price P1.
Because the industry is in long-run equilibrium, the price equals the minimum point on
the representative firm's average total cost curve, so the firm produces output q1 and
makes zero profit.
b.
The increase in jewelry demand leads to an increase in the demand for gold, shifting the
demand curve to D2. In the short run, the price rises to P2, industry output rises to Q2,
and the representative firm's output rises to q2. Because price now exceeds average
total cost, the representative firm now earns positive profits.
c.
Because gold mines are earning positive economic profits, over time other firms will
enter the industry. This will shift the supply curve to the right, reducing the price below
P2. But it is unlikely that the price will fall all the way back to P1, because gold is in short
supply. Costs for new firms are likely to be higher than for older firms, because they will
have to discover new gold sources. So it is likely that the long-run supply curve in the
Chapter 14/Firms in Competitive Markets ) 287
gold industry is upward sloping. That means that the long-run equilibrium price will be
higher than it was initially.
Figure 12
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15
MONOPOLY
WHAT’S NEW IN THE FOURTH EDITION:
There is a new In the News box on “TKTS and Other Schemes” in which economist Hal Varian discusses a
dramatic example of price discrimination (the pricing of Broadway shows).
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
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¾
why some markets have only one seller.
¾
how a monopoly determines the quantity to produce and the price to charge.
¾
how the monopoly’s decisions affect economic well-being.
¾
the various public policies aimed at solving the problem of monopoly.
¾
why monopolies try to charge different prices to different customers.
CONTEXT AND PURPOSE:
Chapter 15 is the third chapter in a five-chapter sequence dealing with firm behavior and the organization
of industry. Chapter 13 developed the cost curves on which firm behavior is based. These cost curves
were employed in Chapter 14 to show how a competitive firm responds to changes in market conditions.
In Chapter 15, these cost curves are again employed, this time to show how a monopolistic firm chooses
the quantity to produce and the price to charge. Chapters 16 and 17 will address the decisions made by
oligopolistic and monopolistically competitive firms.
A monopolist is the sole seller of a product without close substitutes. As such, it has market
power because it can influence the price of its output. That is, a monopolist is a price maker as opposed
to a price taker. The purpose of Chapter 15 is to examine the production and pricing decisions of
monopolists, the social implications of their market power, and the ways in which governments might
respond to the problems caused by monopolists.
289
290 ) Chapter 15/Monopoly
KEY POINTS:
1. A monopoly is a firm that is the sole seller in its market. A monopoly arises when a single firm owns a
key resource, when the government gives a firm the exclusive right to produce a good, or when a
single firm can supply the entire market at a smaller cost than many firms could.
2. Because a monopoly is the sole producer in its market, it faces a downward-sloping demand curve for
its product. When a monopoly increases production by one unit, it causes the price of its good to fall,
which reduces the amount of revenue earned on all units produced. As a result, a monopoly’s
marginal revenue is always below the price of its good.
3. Like a competitive firm, a monopoly firm maximizes profit by producing the quantity at which
marginal revenue equals marginal cost. The monopoly then chooses the price at which that quantity
is demanded. Unlike a competitive firm, a monopoly firm’s price exceeds its marginal revenue, so its
price exceeds marginal cost.
4. A monopolist’s profit-maximizing level of output is below the level that maximizes the sum of
consumer and producer surplus. That is, when the monopoly charges a price above marginal cost,
some consumers who value the good more than its cost of production do not buy it. As a result,
monopoly causes deadweight losses similar to the deadweight losses caused by taxes.
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5. Policymakers can respond to the inefficiency of monopoly behavior in four ways. They can use the
antitrust laws to try to make the industry more competitive. They can regulate the prices that the
monopoly charges. They can turn the monopolist into a government-run enterprise. Or, if the market
failure is deemed small compared to the inevitable imperfections of policies, they can do nothing at
all.
6. Monopolists often can raise their profits by charging different prices for the same good based on the
buyer’s willingness to pay. This practice of price discrimination can raise economic welfare by getting
the good to some consumers who otherwise would not buy it. In the extreme case of perfect price
discrimination, the deadweight losses of monopoly are completely eliminated. More generally, when
price discrimination is imperfect, it can either raise or lower welfare compared to the outcome with a
single monopoly price.
CHAPTER OUTLINE:
I.
A competitive firm is a price taker; a monopoly firm is a price maker.
II.
Why Monopolies Arise
A.
Definition of monopoly: a firm that is the sole seller of a product without close
substitutes.
B.
The fundamental cause of monopoly is barriers to entry.
1.
Monopoly Resources
a.
A monopoly could have sole ownership or control of a key resource that
is used in the production of the good.
Chapter 15/Monopoly ) 291
b.
Case Study: The DeBeers Diamond Monopoly—this firm controls about
80% of the diamonds in the world.
2.
3.
Government-Created Monopolies
a.
Monopolies can arise because the government grants one person or one
firm the exclusive right to sell some good or service.
b.
Patents are issued by the government to give firms the exclusive right to
produce a product for 20 years.
c.
Patents involve trade-offs; they restrict competition but encourage
research and development.
Natural Monopolies
a.
Definition of natural monopoly: a monopoly that arises because a
single firm can supply a good or service to an entire market at a
smaller cost than could two or more firms.
b.
A natural monopoly occurs when there are economies of scale, implying
that average total cost falls as the firm's scale becomes larger.
Figure 1
III.
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How Monopolies Make Production and Pricing Decisions
A.
Monopoly versus Competition
Figure 2
1.
The key difference between a competitive firm and a monopoly is the monopoly's
ability to influence the price of its output.
2.
The demand curves that each of these types of firms faces is different as well.
a.
A competitive firm faces a perfectly elastic demand at the market price.
The firm can sell all that it wants to at this price.
b.
A monopoly faces the market demand curve because it is the only seller
in the market. If a monopoly wants to sell more output, it must lower
the price of its product.
292 ) Chapter 15/Monopoly
B.
A Monopoly's Revenue
Table 1
1.
Example: sole producer of water in a town.
Quantity
Price
Total Revenue
Average Revenue
Marginal Revenue
0
$11
$0
----
----
1
10
10
$10
$10
2
9
18
9
8
3
8
24
8
6
4
7
28
7
4
5
6
30
6
2
6
5
30
5
0
7
4
28
4
-2
8
3
24
3
-4
2.
A monopoly's marginal revenue will always be less than the price of the good
(other than at the first unit sold).
PMG
a.
If the monopolist sells one more unit, his total revenue (P x Q) will rise
because Q is getting larger. This is called the output effect.
b.
If the monopolist sells one more unit, he must lower price. This means
that his total revenue (P x Q) will fall because P is getting smaller. This is
called the price effect.
ALTERNATIVE CLASSROOM EXAMPLE:
The Whatsa Widget Company has a monopoly in the sale of widgets. The demand the firm
faces can be shown by the following schedule:
Quantity
0
1
2
3
4
5
Price
$15
14
13
12
11
10
Total Revenue
$0
14
26
36
44
50
Marginal Revenue
---$14
12
10
8
6
Students often have trouble with this. Go through the table making sure that they
understand the calculation of both total revenue and marginal revenue as output
increases. Emphasize that the monopolist is setting one price and sticking to it rather
than having the ability to set the price and lower it little by little as he wishes to sell
more.
c.
Note that, for a competitive firm, there is no price effect.
Chapter 15/Monopoly ) 293
Figure 3
PMG
3.
When graphing the firm's demand and marginal revenue curve, they always start at the
same point (because P = MR for the first unit sold); for every other level of output,
marginal revenue lies below the demand curve (because MR < P).
At this point, you may want to discuss the price elasticity of demand again. Remind
students that demand tends to be elastic along the upper left-hand portion of the
demand curve. Thus, a decrease in price causes total revenue to increase (so that
marginal revenue is greater than zero). Further down the demand curve, the demand
is inelastic. In this region, a decrease in price results in a drop in total revenue
(implying that marginal revenue is now less than zero).
C.
Profit Maximization
1.
2.
The monopolist's profit-maximizing quantity of output occurs where marginal
revenue is equal to marginal cost.
a.
If marginal revenue is greater than marginal cost, profit can be increased
by raising the firm’s level of output.
b.
If marginal revenue is less than marginal cost, profit can be increased by
lowering the firm’s level of output.
Even though MR = MC is the profit-maximizing rule for both competitive firms
and monopolies, there is one important difference.
a.
b.
In competitive firms, P = MR; at the profit-maximizing level of output, P
= MC.
In a monopoly, P > MR; at the profit-maximizing level of output,
P > MC.
294 ) Chapter 15/Monopoly
3.
The monopolist's price is determined by the demand curve (which shows us how
much buyers are willing to pay for the product).
ALTERNATIVE CLASSROOM EXAMPLE:
The costs for the Whatsa Widget Company can be represented by the following schedule:
Quantity
0
1
2
3
4
5
Total Cost
$8
11
16
26
39
57
Marginal Cost
---$3
5
10
13
18
Using the earlier information regarding the demand for widgets, have the students find the
profit-maximizing level of output (where marginal revenue is equal to marginal cost). Use the
information on total revenue and total cost to calculate the level of maximum profit.
PMG
Figure 4
After having seen profit-maximization for a perfectly competitive firm, students
generally do not have difficulty understanding that a monopolist will maximize profit
where marginal revenue equals marginal cost. However, students do have trouble
remembering to use the demand curve to find the monopolist’s price. Thus, be
careful to review this point several times.
Chapter 15/Monopoly ) 295
D.
A Monopoly's Profit
1.
We can find profit using the following equation:
Profit = TR – TC.
2.
Because TR = P x Q and TC = ATC x Q, we can rewrite this equation:
Profit = (P – ATC) x Q.
Figure 5
PMG
E.
F.
FYI: Why a Monopoly Does Not Have a Supply Curve
1.
A supply curve tells us the quantity that a firm chooses to supply at any given
price.
2.
But a monopoly firm is a price maker; the firm sets the price at the same time it
chooses the quantity to supply.
3.
It is the market demand curve that tells us how much the monopolist will supply
because the shape of the demand curve determines the shape of the marginal
revenue curve (which in turn determines the profit-maximizing level of output).
Case Study: Monopoly Drugs versus Generic Drugs
Figure 6
1.
The market for pharmaceutical drugs takes on both monopoly characteristics and
competitive characteristics.
296 ) Chapter 15/Monopoly
IV.
2.
When a firm discovers a new drug, patent laws give the firm a monopoly on the
sale of that drug. However, the patent eventually expires and any firm can make
the drug, which causes the market to become competitive.
3.
Analysis of the pharmaceutical industry has shown us that prices of drugs fall
after patents expire and new firms begin production of that drug.
The Welfare Cost of Monopoly
A.
The Deadweight Loss
Figure 7
1.
The demand curve represents the value that buyers place on each additional unit
of a good or service. The marginal-cost curve represents the additional cost of
producing each unit of a good or service.
2.
The socially efficient quantity of output is found where the demand curve and
the marginal cost curve intersect. This is where total surplus is maximized.
Remind students that total surplus is the area between the demand curve and the
marginal cost curve. It should be clear that surplus is not realized for quantities of
output between the monopoly output and the socially efficient output.
PMG
Figure 8
3.
Because the monopolist sets marginal revenue equal to marginal cost to
determine its output level, it will produce less than the socially efficient quantity
of output.
4.
The price that a monopolist charges is also above marginal cost. Although some
potential customers value the good at more than its marginal cost but less than
the monopolist’s price, they do not purchase the good even though that is
inefficient because total surplus is not maximized.
Chapter 15/Monopoly ) 297
5.
The deadweight loss can be seen on the graph as the area between the demand
and marginal cost curves for the units between the monopoly quantity and the
efficient quantity.
Point out to students that this is similar to the analysis of taxes in Chapter 8. Here,
the monopolist places a wedge between price and marginal cost and the quantity
sold ends up being short of the optimum level.
B.
V.
The Monopoly's Profit: A Social Cost?
1.
Welfare in a market includes the welfare of both consumers and producers.
2.
The transfer of surplus from consumers to producers is therefore not a social
loss.
3.
The deadweight loss from monopoly stems from the fact that monopolies
produce less than the socially efficient level of output.
4.
If the monopoly incurs costs to maintain (or create) its monopoly power, those
costs would also be included in deadweight loss.
PMG
Public Policies toward Monopolies
A.
Increasing Competition with Antitrust Laws
1.
2.
3.
Antitrust laws are a collection of statutes that give the government the authority
to control markets and promote competition.
a.
The Sherman Antitrust Act was passed in 1890 to lower the market
power of the large and powerful "trusts” that were viewed as dominating
the economy at that time.
b.
The Clayton Act was passed in 1914; it strengthened the government's
ability to curb monopoly power and authorized private lawsuits.
Antitrust laws allow the government to prevent mergers and break up large,
dominating companies.
Antitrust laws also impose costs on society. Some mergers may provide
synergies, which occur when the costs of operations fall because of joint
operations.
B.
Regulation
1.
Regulation is often used when the government is dealing with a natural
monopoly.
Local phone and electric companies are good examples of regulated monopoly firms.
2.
Most often, regulation involves government limits on the price of the product.
298 ) Chapter 15/Monopoly
3.
While we might believe that the government can eliminate the deadweight loss
from monopoly by setting the monopolist's price equal to its marginal cost, this is
often difficult to do.
Figure 9
4.
a.
If the firm is a natural monopoly, its average total cost curve will be
declining because of its economies of scale.
b.
When average total cost is falling, marginal cost must be lower than
average total cost.
c.
Therefore, if the government sets price equal to marginal cost, the price
will be below average total cost and the firm will earn a loss, causing the
firm to eventually leave the market.
Therefore, governments may choose to set the price of the monopolist's product
equal to its average total cost. This gives the monopoly zero profit, but assures
that it will remain in the market.
PMG
C.
D.
E.
a.
There is still a deadweight loss in this situation because the level of
output will be lower than the socially efficient level of output.
b.
Average-cost pricing also provides no incentive for the monopolist to
reduce costs.
Public Ownership
1.
Rather than regulating a monopoly run by a private firm, the government can
run the monopoly itself.
2.
However, economists generally prefer private ownership of natural monopolies.
a.
Private owners have an incentive to keep costs down to earn higher
profits.
b.
If government bureaucrats do a bad job running a monopoly, the
political system is the taxpayers’ only recourse.
Doing Nothing
1.
Sometimes the costs of government regulation outweigh the benefits.
2.
Therefore, some economists believe that it is best for the government to leave
monopolies alone.
In the News: Public Transport and Private Enterprise
1.
In New York, thousands of illegal drivers of buses and taxicabs provide
transportation services that are often cheaper and preferred to the governmentprovided (or licensed) services.
Chapter 15/Monopoly ) 299
2.
VI.
This is an article from The New York Times Magazine describing this situation.
Price Discrimination
A.
Definition of price discrimination: the business practice of selling the same good
at different prices to different customers.
B.
A Parable about Pricing
1.
Example: Readalot Publishing Company
2.
The firm pays an author $2 million for the right to publish a book. (Assume that
the cost of printing the book is zero.)
3.
The firm knows that there are two types of readers.
a.
There are 100,000 die-hard fans of the author willing to pay up to $30
for the book.
b.
There are 400,000 other readers who will be willing to pay up to $5 for
the book.
PMG
4.
5.
How should the firm set its price?
a.
If the firm sets its price equal to $30, it will sell 100,000 copies of the
book, receive total revenue of $3 million, and earn $1 million in profit.
b.
If the firm sets its price equal to $5, it will sell 500,000 copies, receive
total revenue of $2.5 million, and earn only $500,000 in profit.
c.
It will choose to set its price at $30 and sell 100,000 books. Note that
there is a deadweight loss from this decision because there are 400,000
other customers willing to pay $5, which is more than the marginal cost
of producing the book ($0).
If there was a way to guarantee that those readers willing to pay $30 could not
buy a copy of the book from those willing to pay $5 (if they lived far away from
one another), the company could make even more profit by selling 100,000
copies to the die-hard fans at $30 each, and then selling 400,000 copies to the
other readers for $5 each.
a.
The total revenue from selling 100,000 copies at $30 each is $3 million.
b.
The total revenue from selling 400,000 copies at $5 each is $2 million.
c.
Because the firm's costs are $2 million, profit will be $3 million.
300 ) Chapter 15/Monopoly
Activity 1— Price Discrimination and Time Travel
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Price discrimination, consumer surplus
None
10 minutes
Works in any size class
Purpose
This example illustrates how a price-discriminating monopolist can earn even higher profits
than a monopolist charging a single price. The example uses an imaginary time machine to
look at monopoly profits and consumer surplus. The cases of competition, monopoly, and
price discriminating monopoly are examined.
Instructions
Use student names in the demand for time travel shown below.
“Steve” wants to travel back in time to see the dinosaurs; he is willing to pay as much as
$200 to use the time machine
“Joyce” wants to relive this entire semester; she is willing to pay up to $150 to use the
time machine.
“Chip” can’t wait for the semester to end; he is willing to pay as much as $125 to use the
time machine
“Dawn” just wants to get through this class period; she is willing to pay up to $100 to use
the time machine.
PMG
The demand curve for time travel is:
Price
$200
150
125
100
Quantity
1
2
3
4
For simplicity, let the marginal cost of time travel be constant at $100. If time travel was a
competitive industry, price would equal marginal cost ($100) and 4 trips would be sold.
C.
The Moral of the Story
1.
By charging different prices to different customers, a monopoly firm can increase
its profit.
2.
To price discriminate, a firm must be able to separate customers by their
willingness to pay.
3.
Arbitrage (the process of buying a good in one market at a low price and then
selling it in another market at a higher price) will limit a monopolist's ability to
price discriminate.
Price discrimination can increase economic welfare. Producer surplus rises
(because price exceeds marginal cost for all of the units sold) while consumer
surplus is unchanged (because price is equal to the consumers’ willingness to
pay).
4.
Chapter 15/Monopoly ) 301
Figure 10
D.
The Analytics of Price Discrimination
1.
Perfect price discrimination describes a situation where a monopolist knows
exactly the willingness to pay of each customer and can charge each customer a
different price.
2.
Without price discrimination, a firm produces an output level that is lower than
the socially efficient level.
3.
If a firm perfectly price discriminates, each customer who values the good at
more than its marginal cost will purchase the good and be charged his or her
willingness to pay.
a.
There is no deadweight loss in this situation.
b.
Because consumers pay a price exactly equal to their willingness to pay,
all surplus in this market will be producer surplus.
PMG
E.
F.
Examples of Price Discrimination
1.
Movie Tickets
2.
Airline Prices
3.
Discount Coupons
4.
Financial Aid
5.
Quantity Discounts
In the News: TKTS and Other Schemes
1.
Every night in New York City, about 25,000 people attend Broadway shows (on
average).
2.
This is an article written by economist Hal Varian that describes the level of price
discrimination that occurs in this market.
Table 2
VII.
Conclusion: The Prevalence of Monopoly
A.
Monopoly firms behave very differently from competitive firms.
B.
Table 2 summarizes the key similarities and differences between monopoly and
competitive markets.
302 ) Chapter 15/Monopoly
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
A market might have a monopoly because: (1) a key resource is owned by a single firm; (2) the
government gives a single firm the exclusive right to produce some good; or (3) the costs of
production make a single producer more efficient than a large number of producers.
Examples of monopolies include: (1) the water producer in a small town, who owns a key
resource, the one well in town; (2) a pharmaceutical company that is given a patent on a new
drug by the government; and (3) a bridge, which is a natural monopoly because (if the bridge is
uncongested) having just one bridge is efficient. Many other examples are possible.
2.
A monopolist chooses the amount of output to produce by finding the quantity at which marginal
revenue equals marginal cost. It finds the price to charge by finding the point on the demand
curve that corresponds to that quantity.
3.
A monopolist produces a quantity of output that is less than the quantity of output that
maximizes total surplus because it produces the quantity at which marginal cost equals marginal
revenue rather than the quantity at which marginal cost equals price.
4.
5.
PMG
Policymakers can respond to the inefficiencies caused by monopolies in one of four ways: (1) by
trying to make monopolized industries more competitive; (2) by regulating the behavior of the
monopolies; (3) by turning some private monopolies into public enterprises; or (4) by doing
nothing at all. Antitrust laws prohibit mergers of large companies and prevent large companies
from coordinating their activities in ways that make markets less competitive, but such laws may
keep companies from merging and generating synergies that increase efficiency. Some
monopolies, especially natural monopolies, are regulated by the government, but it is hard to
keep a monopoly in business, achieve marginal-cost pricing, and give the monopolist an incentive
to reduce costs. Private monopolies can be taken over by the government, but the companies
are not likely to be well run. Sometimes doing nothing at all may seem to be the best solution,
but there are clearly deadweight losses from monopoly that society will have to bear.
Examples of price discrimination include: (1) movie tickets, for which children and senior citizens
get lower prices; (2) airline prices, which are different for business and leisure travelers; (3)
discount coupons, which lead to different prices for people who value their time in different
ways; (4) financial aid, which offers college tuition at lower prices to poor students and higher
prices to wealthy students; and (5) quantity discounts, which offer lower prices for higher
quantities, capturing more of a buyer’s willingness to pay. Many other examples are possible.
Compared to a monopoly that charges a single price, perfect price discrimination reduces
consumer surplus, increases producer surplus, and increases total surplus because there is no
deadweight loss.
Questions for Review
1.
Government-created monopoly comes from the existence of patent and copyright laws. Both
allow firms or individuals to be monopolies for extended periods of time—20 years for patents,
the life of the author plus 70 years for copyrights. But this monopoly power is good, because
Chapter 15/Monopoly ) 303
without it, no one would write a book or a song and no firm would invest in research and
development to invent new products or pharmaceuticals.
2.
An industry is a natural monopoly when a single firm can supply a good or service to an entire
market at a smaller cost than could two or more firms. As a market grows, it may evolve from a
natural monopoly to a competitive market.
3.
A monopolist's marginal revenue is less than the price of its product because its demand curve is
the market demand curve. Thus, to increase the amount sold, the monopolist must lower the
price of its good for every unit it sells. This cut in price reduces the revenue on the units it was
already selling.
A monopolist's marginal revenue can be negative because to get purchasers to buy an additional
unit of the good, the firm must reduce its price on all units of the good. The fact that it sells a
greater quantity increases the firm’s revenue, but the decline in price decreases the firm’s
revenue. The overall effect depends on the price elasticity of demand. If demand is inelastic,
marginal revenue will be negative.
4.
Figure 1 shows the demand, marginal-revenue, and marginal-cost curves for a monopolist. The
intersection of the marginal-revenue and marginal-cost curves determines the profit-maximizing
level of output, Qm. The profit-maximizing price, Pm can be found using the demand curve.
PMG
Figure 1
5.
The level of output that maximizes total surplus in Figure 1 is where the demand curve intersects
the marginal-cost curve, Qc. The deadweight loss from monopoly is the triangular area between
Qc and Qm that is above the marginal-cost curve and below the demand curve. It represents
deadweight loss, because society loses total surplus because of the monopoly. The deadweight
loss is equal to the value of the good (measured by the height of the demand curve) less the cost
of production (given by the height of the marginal-cost curve), for the quantities between Qm and
Qc.
304 ) Chapter 15/Monopoly
6.
The government has the power to regulate mergers between firms because of antitrust laws.
Firms might want to merge to increase operating efficiency and reduce costs, something that is
good for society, or to gain market power, which is bad for society.
7.
When regulators tell a natural monopoly that it must set price equal to marginal cost, two
problems arise. The first is that, because a natural monopoly has a marginal cost that is always
less than average total cost, setting price equal to marginal cost means that the price is less than
average total cost, so the firm will incur a loss. The firm would then exit the industry unless the
government subsidized it. However, getting revenue for such a subsidy would cause the
government to raise other taxes, increasing the deadweight loss. The second problem of using
costs to set price is that it gives the monopoly no incentive to reduce costs.
8.
One example of price discrimination is in publishing books. Publishers charge a much higher price
for hardback books than for paperback books—far higher than the difference in production costs.
Publishers do this because die-hard fans will pay more for a hardback book when the book is first
released. Those who don't value the book as highly will wait for the paperback version to come
out. The publisher makes a greater profit this way than if it charged just one price.
A second example is the pricing of movie tickets. Theaters give discounts to children and senior
citizens because they have a lower willingness to pay for a ticket. Charging different prices helps
the theater increase its profit above what it would be if it charged just one price.
PMG
Many other examples are possible.
Problems and Applications
1.
The following table shows revenue, costs, and profits, where quantities are in thousands, and
total revenue, total cost, and profit are in millions of dollars:
Price
$100
90
80
70
60
50
40
30
20
10
0
Quantity
(1,000s)
0
100
200
300
400
500
600
700
800
900
1,000
Total
Revenue
$0
9
16
21
24
25
24
21
16
9
0
Marginal
Revenue
---$9
7
5
3
1
-1
-3
-5
-7
-9
Total
Cost
$2
3
4
5
6
7
8
9
10
11
12
Profit
$-2
6
12
16
18
18
16
12
6
-2
-12
a.
A profit-maximizing publisher would choose a quantity of 400,000 at a price of $60 or a
quantity of 500,000 at a price of $50; both combinations would lead to profits of $18
million.
b.
Marginal revenue is always less than price. Price falls when quantity rises because the
demand curve slopes downward, but marginal revenue falls even more than price
because the firm loses revenue on all the units of the good sold when it lowers the price.
Chapter 15/Monopoly ) 305
c.
Figure 2 shows the marginal-revenue, marginal-cost, and demand curves. The marginalrevenue and marginal-cost curves cross between quantities of 400,000 and 500,000. This
signifies that the firm maximizes profits in that region.
PMG
Figure 2
d.
The area of deadweight loss is marked “DWL” in the figure. Deadweight loss means that
the total surplus in the economy is less than it would be if the market were competitive,
because the monopolist produces less than the socially efficient level of output.
e.
If the author were paid $3 million instead of $2 million, the publisher would not change
the price, because there would be no change in marginal cost or marginal revenue. The
only thing that would be affected would be the firm’s profit, which would fall.
f.
To maximize economic efficiency, the publisher would set the price at $10 per book,
because that is the marginal cost of the book. At that price, the publisher would have
negative profits equal to the amount paid to the author.
306 ) Chapter 15/Monopoly
Figure 3
2.
3.
Figure 3 illustrates a natural monopolist setting price, PATC, equal to average total cost. The
quantity produced is QATC. Marginal cost pricing would yield the price PMC and quantity QMC. For
quantities between QATC and QMC, the benefit to consumers (measured by the height of the
demand curve) exceeds the cost of production (measured by the height of the marginal-cost
curve). This means that the deadweight loss from setting price equal to average total cost is the
triangular area shown in the figure.
PMG
If the price of tap water rises, the demand for bottled water increases. This is shown in Figure 4
as a shift to the right in the demand curve from D1 to D2. The corresponding marginal-revenue
curves are MR1 and MR2. The profit-maximizing level of output is where marginal cost equals
marginal revenue. Prior to the increase in the price of tap water, the profit-maximizing level of
output is Q1; after the price increase, it rises to Q2. The profit-maximizing price is shown on the
demand curve: it is P1 before the price of tap water rises, but rises to P2. Average total cost is
AC1 before the price of tap water rises and AC2 after. Profit increases from (P1 − AC1) x Q1 to (P2
− AC2) x Q2.
Figure 4
Chapter 15/Monopoly ) 307
4.
a.
Figure 5 illustrates the market for groceries when there are many competing
supermarkets with constant marginal cost. Output is QC, price is PC, consumer surplus is
area A, producer surplus is zero, and total surplus is area A.
PMG
Figure 5
b.
If the supermarkets merge, Figure 6 illustrates the new situation. Quantity declines from
QC to QM and price rises to PM. Consumer surplus falls by areas D + E + F to areas B +
C. Producer surplus becomes areas D + E, and total surplus is areas B + C + D + E.
Consumers transfer the amount of areas D + E to producers and the deadweight loss is
area F.
Figure 6
308 ) Chapter 15/Monopoly
5.
6.
a.
The following table shows total revenue and marginal revenue for each price and
quantity sold:
Price
Quantity
24
22
20
18
16
14
10,000
20,000
30,000
40,000
50,000
60,000
Total
Revenue
$240,000
440,000
600,000
720,000
800,000
840,000
Marginal
Revenue
---$20
16
12
8
4
Total
Cost
$50,000
100,000
150,000
200,000
250,000
300,000
Profit
$190,000
340,000
450,000
520,000
550,000
540,000
b.
Profits are maximized at a price of $16 and quantity of 50,000. At that point, profit is
$550,000.
c.
As Johnny's agent, you should recommend that he demand $550,000 from them, so he
receives all of the profit (rather than the record company).
a.
The table below shows total revenue and marginal revenue for the bridge. The profitmaximizing price would be where revenue is maximized, which will occur where marginal
revenue equals zero, because marginal cost equals zero. This occurs at a price of $4 and
quantity of 400. The efficient level of output is 800, because that is where price is equal
to marginal cost. The profit-maximizing quantity is lower than the efficient quantity
because the firm is a monopolist.
PMG
Price
$8
7
6
5
4
3
2
1
0
Quantity
0
100
200
300
400
500
600
700
800
Total Revenue
$0
700
1,200
1,500
1,600
1,500
1,200
700
0
Marginal Revenue
---$7
5
3
1
-1
-3
-5
-7
b.
The company should not build the bridge because its profits are negative. The most
revenue it can earn is $1,600,000 and the cost is $2,000,000, so it would lose $400,000.
c.
If the government were to build the bridge, it should set price equal to marginal cost to
be efficient. Since marginal cost is zero, the government should not charge people to use
the bridge.
Chapter 15/Monopoly ) 309
Figure 7
d.
7.
Yes, the government should build the bridge, because it would increase society's total
surplus. As shown in Figure 7, total surplus has area ½x 8 x 800,000 = $3,200,000,
which exceeds the cost of building the bridge.
PMG
a.
Figure 8 illustrates the drug company's situation. They will produce quantity Q1 at price
P1. Profits are equal to (P1 − AC1) x Q1.
Figure 8
310 ) Chapter 15/Monopoly
b.
A tax on the drug increases both marginal cost and average total cost by the amount of
the tax. As a result, as shown in Figure 9, the profit-maximizing quantity is reduced to
Q2, price rises to P2, and average total cost plus tax rises to AC2.
Figure 9
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c.
The tax definitely reduces the firm’s profits. After all, the firm could have produced
quantity Q2 at price P2 before the tax was imposed, but it chose not to because this level
did not maximize profit before the tax occurred.
d.
A flat tax of $10,000 regardless of how many bottles of the drug are produced would
leave the quantity produced at Q1 and the price at P1 in Figure 8 because such a tax does
not affect marginal cost or marginal revenue. It does, however, raise average total cost
and profits would decline by exactly $10,000.
Chapter 15/Monopoly ) 311
8.
Larry wants to sell as many drinks as possible without losing money, so he wants to set quantity
where price (demand) equals average total cost, which occurs at quantity QL and price PL in
Figure 10. Curly wants to bring in as much revenue as possible, which occurs where marginal
revenue equals zero, at quantity QC and price PC. Moe wants to maximize profits, which occurs
where marginal cost equals marginal revenue, at quantity QM and price PM.
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Figure 10
9.
a.
Long-distance phone service was originally a natural monopoly because the installation of
phone lines across the country meant that one firm's costs were much lower than if two
or more firms did the same thing.
b.
With communications satellites, the cost is no different if one firm supplies long-distance
calls or if many firms do so. So the industry evolved from a natural monopoly to a
competitive market.
c.
It is efficient to have competition in long-distance phone service and regulated
monopolies in local phone service because local phone service remains a natural
monopoly (being based on landlines) while long-distance service is a competitive market
(being based on satellites).
312 ) Chapter 15/Monopoly
10.
a.
The patent gives the company a monopoly, as shown in Figure 11. At a quantity of QM
and price of PM, consumer surplus is area A + B, producer surplus is area C + D, and
total surplus is area A + B + C + D.
b.
If the firm can perfectly price discriminate, it will produce quantity QC and extract all of
the consumer surplus. Consumer surplus is zero and producer surplus is A + B + C + D
+ E. Total surplus is also A + B + C + D + E. The deadweight loss is reduced to zero.
There is a transfer of surplus from consumers to producers of areas A + B.
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Figure 11
11.
A monopolist always produces a quantity at which demand is elastic. If the firm produced a
quantity for which demand was inelastic, then if the firm raised its price, quantity would fall by a
smaller percentage than the rise in price, so revenue would increase. Because costs would
decrease at a lower quantity, the firm would have higher revenue and lower costs, so profit
would be higher. Thus the firm should keep raising its price until profits are maximized, which
must happen on an elastic portion of the demand curve.
Another way to see this is to note that on an inelastic portion of the demand curve, marginal
revenue is negative. Increasing quantity requires a greater percentage reduction in price, so
revenue declines. Because a firm maximizes profit where marginal cost equals marginal revenue,
and marginal cost is never negative, the profit-maximizing quantity can never occur where
marginal revenue is negative. Thus, it can never be on the inelastic portion of the demand curve.
12.
Though Avril Lavigne has a monopoly on her own singing, there are many other singers in the
market. If Lavigne were to raise her price too much, people would substitute to other singers.
Therefore, there is no need for the government to regulate the price of her concerts.
Chapter 15/Monopoly ) 313
13.
a.
Price
10
9
8
7
6
5
4
3
2
1
0
Price
10
9
8
7
6
5
4
3
2
1
0
The marginal revenue from selling to each type of consumer is shown in the following
tables:
Quantity of Adult
Tickets
0
100
200
300
300
300
300
300
300
300
300
Total Revenue from Sale
of Adult Tickets
0
900
1,600
2,100
1,800
1,500
1,200
900
600
300
0
Marginal Revenue from
Sale of Adult Tickets
---9
7
5
-3
-3
-3
-3
-3
-3
-3
Quantity of Child
Tickets
0
0
0
0
0
100
200
200
200
200
200
Total Revenue from Sale
of Child Tickets
0
0
0
0
0
500
800
600
400
200
0
Marginal Revenue from
Sale of Child Tickets
---0
0
0
0
5
3
-2
-2
-2
-2
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To maximize profit, you should charge adults $7 and sell 300 tickets. You should charge
children $4 and sell 200 tickets. Total revenue will be $2,100 + $400 = $2,500. Because
total cost is $2,000, profit will be $900.
b.
If price discrimination were not allowed, you would want to set a price of $7 for the
tickets. You would sell 300 tickets and profit would be $100.
c.
The children who were willing to pay $4 but will not see the show now that the price is
$7 will be worse off. The producer is worse off because profit is lower. Total surplus is
lower. There is no one that is better off.
314 ) Chapter 15/Monopoly
14.
a.
Figure 12 shows the cost, demand, and marginal-revenue curves for the monopolist.
Without price discrimination, the monopolist would charge price PM and produce quantity
QM.
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Figure 12
b.
The monopolist's profit consists of the two areas labeled X, consumer surplus is the two
areas labeled Y, and the deadweight loss is the area labeled Z.
c.
If the monopolist can perfectly price discriminate, it produces quantity QC, and has profit
equal to X + Y + Z.
d.
The monopolist's profit increases from X to X + Y + Z, an increase in the amount Y + Z.
The change in total surplus is area Z. The rise in the monopolist's profit is greater than
the change in total surplus, because the monopolist's profit increases both by the amount
of deadweight loss (Z) and by the transfer from consumers to the monopolist (Y).
e.
A monopolist would pay the fixed cost that allows it to discriminate as long as Y + Z (the
increase in profits) exceeds C (the fixed cost).
f.
A benevolent social planner who cared about maximizing total surplus would want the
monopolist to price discriminate only if Z (the deadweight loss from monopoly) exceeded
C (the fixed cost) because total surplus rises by Z − C.
g.
The monopolist has a greater incentive to price discriminate (it will do so if Y + Z > C)
than the social planner would allow (she would allow it only if Z > C). Thus if Z < C but Y
+ Z > C, the monopolist will price discriminate even though it is not in society's best
interest.
Chapter 16
Oligopoly
16
OLIGOPOLY
WHAT’S NEW IN THE FOURTH EDITION:
There is a new discussion of concentration ratios. There is a new In the News box on “The Global Fight
against Cartels” that discusses how price fixing by cartels is illegal in most countries.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
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¾
what market structures lie between monopoly and competition.
¾
what outcomes are possible when a market is an oligopoly.
¾
the prisoners’ dilemma and how it applies to oligopoly and other issues.
¾
how the antitrust laws try to foster competition in oligopolistic markets.
CONTEXT AND PURPOSE:
Chapter 16 is the fourth chapter in a five-chapter sequence dealing with firm behavior and the
organization of industry. The previous two chapters discussed the two extreme forms of market
structure—competition and monopoly. The market structure that lies between competition and monopoly
is known as imperfect competition. There are two types of imperfect competition—oligopoly and
monopolistic competition. Chapter 16 addresses oligopoly while the final chapter in this sequence,
Chapter 17, addresses monopolistic competition.
The purpose of Chapter 16 is to discuss oligopoly—a market structure in which only a few sellers
offer similar or identical products. Because there are only a few sellers in an oligopolistic market,
oligopolistic firms are interdependent whereas competitive firms are not. That is, in a competitive market,
the decisions of one firm have no impact on the other firms in the market while in an oligopolistic market,
the decisions of any one firm may affect the pricing and production decisions of the other firms in the
market.
315
316 ) Chapter 16/Oligopoly
KEY POINTS:
1. Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. Yet, if
oligopolists make decisions about production levels individually, the result is a greater quantity and a
lower price than under the monopoly outcome. The larger the number of firms in the oligopoly, the
closer the quantity and price will be to the levels that would prevail under competition.
2. The prisoners’ dilemma shows that self-interest can prevent people from maintaining cooperation,
even when cooperation is in their mutual interest. The logic of the prisoners’ dilemma applies in many
situations including arms races, advertising, common-resource problems, and oligopolies.
3. Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces
competition. The application of these laws can be controversial, because some behavior that may
seem to reduce competition may in fact have legitimate business purposes.
CHAPTER OUTLINE:
I.
Between Monopoly and Perfect Competition
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Figure 1
A.
The typical firm has some market power, but its market power is not as great as that
described by monopoly.
B.
Firms in imperfect competition lie somewhere between the competitive model and the
monopoly model.
C.
Definition of oligopoly: a market structure in which only a few sellers offer
similar or identical products.
1.
Economists measure a market’s domination by a small number of firms with a
statistic called a concentration ratio.
2.
The concentration ratio is the percentage of total output in the market supplied
by the four largest firms.
3.
In the U.S. economy, most industries have a four-firm concentration ratio under
50%.
D.
Definition of monopolistic competition: a market structure in which many firms
sell products that are similar but not identical.
E.
Figure 1 summarizes the four types of market structure. Note that it is the number of
firms and the type of product sold that distinguishes one market structure from another.
Draw a table with the four types of markets across the top. Create rows for various
market characteristics such as type of product sold, number of firms, control over
price, freedom of entry and exit, and ability to earn profit in the long run. Students
will then be able to see how these characteristics relate to one another.
Chapter 16/Oligopoly ) 317
Activity 1 – Think of a Firm
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
Market structure
None
15 minutes
Works in any size class
Purpose
This assignment helps students relate the concept of market structure to the real world.
Instructions
Ask the class to answer the following questions. After they have answered all of them, ask the
students to share their answers with a neighbor. Ask the neighboring student to evaluate the
answer to the last question. List the four market structures on the board and ask for
examples that fit each category
1. Write the name of a specific firm. It should be a real company, not hypothetical.
2. What products or services do this firm sell? If the firm sells a wide variety of goods,
choose a single item to answer the following questions.
3. What other firms compete with this company? Are there many competitors, only a few,
or none?
4. Do the competing firms sell exactly the same product or does each company produce
goods with special characteristics?
5. Categorize the industry as one of the following market structures
a. Competition
— many firms
— identical products
b. Monopoly
— one firm
— unique product
c. Oligopoly
— a few firms
— standard or differentiated product
d. Monopolistic competition
— many firms
— differentiated products
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Common Answers and Points for Discussion
Many students will choose companies that produce consumer goods, where product
differentiation is the most important characteristic. Most of these industries are either
oligopolies or monopolistically competitive. A few students may have examples of monopoly,
particularly utilities or patented medicines. Almost no one will give an example of pure
competition.
Competition, while an economic ideal, does not accurately describe all sectors of the
economy. Explaining that competition is a special case (and adding some examples of
competitive industries) will help students understand why competitive firms face a horizontal
demand curve and have no control over the price of their products.
Some students may have questions about the difference between oligopoly and monopolistic
competition. Differentiating between a “few” and “many” is not always easy. Measures of
market concentration can be used to explain the difference between these two imperfectly
competitive market structures.
318 ) Chapter 16/Oligopoly
In the News: The Growth of Oligopoly
F.
II.
1.
Many industries in the United States, especially those in the world of technology,
media, and communications, are becoming more oligopolistic.
2.
This is an article from The Wall Street Journal describing this trend and
discussing its negative effects.
Markets with Only a Few Sellers
A.
B.
A key feature of oligopoly is the tension between cooperation and self-interest.
1.
The group of oligopolists is better off cooperating and acting like a monopolist,
producing a small quantity of output and charging a price above marginal cost.
2.
Yet, because the oligopolist cares about his own profit, there is an incentive to
act on his own. This will limit the ability of the group to act as a monopoly.
A Duopoly Example
1.
A duopoly is an oligopoly with only two members.
2.
Example: Jack and Jill own the only water wells in town. They have to decide
how much water to bring to town to sell. (Assume that the marginal cost of each
gallon of water is zero.)
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Use this example and show the competitive equilibrium first. Then, show the
monopoly price and output. Finally, explain how the two suppliers would end up
producing a quantity between the competitive and monopoly output and charging a
price between the competitive price and the monopoly price.
Table 1
3.
The demand for the water is as follows:
Quantity (gallons)
Price
Total Revenue (and Total Profit)
0
$120
$0
10
110
1,100
20
100
2,000
30
90
2,700
40
80
3,200
50
70
3,500
60
60
3,600
70
50
3,500
80
40
3,200
90
30
2,700
100
20
2,000
110
10
1,100
120
0
0
Chapter 16/Oligopoly ) 319
C.
Competition, Monopolies, and Cartels
1.
If the market for water were perfectly competitive, price would equal marginal
cost ($0). This means that 120 gallons of water would be sold.
2.
If a monopoly controlled the supply of water, profit would be maximized at a
price of $60 and an output of 60 gallons.
3.
a.
Note that in this case, price ($60) exceeds marginal cost ($0).
b.
This level of output is lower than the socially efficient level of output
(120 gallons).
The duopolists may agree to act together to set the price and quantity of water.
a.
Definition of collusion: an agreement among firms in a market
about quantities to produce or prices to charge.
b.
Definition of cartel: a group of firms acting in unison.
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4.
D.
c.
If Jill and Jack did collude, they would agree on the monopoly outcome
of 60 gallons and a price of $60.
d.
The cartel must also decide how to split the production of water. Each
member will want a larger share because that means more profit.
In the News: The Global Fight against Cartels
a.
Price fixing by cartels is illegal in most nations around the world.
b.
This is an article from The Wall Street Journal discussing the laws in the
United States and Europe that prohibit collusion.
The Equilibrium for an Oligopoly
1.
It is often difficult for oligopolies to form cartels.
a.
Antitrust laws prohibit agreements among firms.
b.
Squabbling among cartel members over their shares is also likely to
occur.
2.
In the absence of a binding agreement, the monopoly outcome is unlikely.
3.
Assume that Jack expects Jill to produce 30 gallons of water (half of the
monopoly outcome).
a.
Jack could also produce 30 gallons and earn a profit of $1,800.
b.
However, he could produce 40 gallons and earn a profit of $2,000.
c.
Jack will want to produce 40 gallons.
320 ) Chapter 16/Oligopoly
4.
Jill might reason the same way. If she expects Jack to produce 30 gallons, she
could increase her profits by raising her output to 40 gallons.
5.
If duopolists pursue their own self-interest when deciding how much to produce,
they produce a quantity greater than the monopoly quantity, charge a price
lower than the monopoly price, and earn total profit less than the monopoly
profit.
6.
Definition of Nash equilibrium: a situation in which economic actors
interacting with one another each choose their best strategy given the
strategies that all the other actors have chosen.
7.
In this example, the Nash equilibrium occurs when both Jack and Jill are
producing 40 gallons.
a.
Given that Jack expects Jill to produce 40 gallons, he will not be better
off at any other output level than 40 gallons.
b.
Given that Jill expects Jack to produce 40 gallons, she will not be better
off at any other output level than 40 gallons.
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E.
8.
Note that the oligopolists could earn a higher total profit if they cooperated with
one another, but instead pursue their own self-interest and earn a lower level of
profit.
9.
When firms in an oligopoly individually choose production to maximize profit,
they end up somewhere between perfect competition and monopoly.
a.
The quantity of output produced by the oligopoly is greater than the
level produced by a monopoly but less than the level produced by a
competitive market.
b.
The oligopoly price is less than the monopoly price but greater than the
competitive price (which implies that it is greater than marginal cost).
How the Size of an Oligopoly Affects the Market Outcome
You might want to point out that the Nash equilibrium will be (n/n + 1) of the
competitive output. Therefore, with two suppliers, the joint output (80 units) will be
two-thirds of the competitive equilibrium (120 units). This will help to explain that as
the number of firms in an oligopoly market increases, the market output quickly
approaches the competitive outcome.
1.
When an oligopolist decides to increase output, two things occur.
a.
Because price is greater than marginal cost, increasing output will
increase profit. This is the output effect.
b.
Because increasing output will raise the total quantity sold, the price will
fall and will therefore lower profit. This is the price effect.
Chapter 16/Oligopoly ) 321
2.
The larger the number of sellers in the industry, the less concerned each seller is
about its own impact on market price.
3.
Thus, as the number of sellers in an oligopoly grows larger, an oligopolistic
market looks more and more like a competitive market.
a.
Price will approach marginal cost.
b.
The quantity of output produced will approach the socially efficient level.
Activity 2—Four Markets for Widgets
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Market structure and price
Seven volunteers, money ($2.50 to $4.00)
15 minutes
Works in any class with more than 15 students
Purpose
This illustrates how different market structures can result in wide differences in price for the
consumer. It also shows how communication can increase oligopoly profits. The opportunity
to win real money creates great student interest.
PMG
Instructions
Divide the class into four groups. Group A consists of one student (the first volunteer). Group
B consists of the next three volunteers. Group C consists of the other three volunteers. Group
D is the rest of the class.
Each group manufactures a unique type of widget. The firms within a group compete, but
there is no competition across groups. Widgets are produced by writing the word “widget” on
a sheet of paper.
Group A represents a monopoly. The monopolist does not need to consider the actions of any
other firms. The professor will buy one widget from Group A. The professor is willing to pay
up to $1 for this widget.
Group B represents an oligopoly. This group can communicate with each other and can
examine each other’s bids. (Have these students sit together.) They are allowed to make their
decisions jointly, and may make agreements to share profits. The professor will buy one
widget from Group B. The professor is willing to pay up to $1.00 for this widget, but will buy
it from the lowest bidder.
Group C also represents an oligopoly. This group cannot communicate with each other. (Move
these students away from each other.) The professor will buy one widget from Group C. The
professor is willing to pay up to $1.00 for this widget, but will buy it from the lowest bidder.
Group D represents competition. The professor will buy one widget from Group D. The
professor is willing to pay up to $1.00 for this widget, but will buy it from the lowest bidder.
322 ) Chapter 16/Oligopoly
Ask the students in each group to make a bid by writing his or her name and offer on a sheet
of paper. Remind them they will need to consider the possible bids by rivals within their own
group, because only the winning bid will be paid.
Collect the bids from each group in turn. Pay the low bid in each group.
Common Answers and Points for Discussion
The monopolist will bid $1, the maximum willingness to pay.
The colluding oligopolists usually each bid $1. They often will reach a profit-sharing
agreement.
The oligopolists who do not communicate will have a lower winning bid. They also display
large variation in the individual bids. Typically the bids range from a low of $0.25 to nearly a
dollar.
The competitive group will also have a range of bids, but the lowest bid will be even lower
than Group C’s low bid. Typically this widget will sell for $0.01.
The relation between market structure and price is displayed nicely. The monopolist charges
100 times the competitive price.
PMG
Communication among oligopolists allows price fixing. Collusion can lead to the joint profitmaximizing, or monopoly, price. Restricting communication greatly reduces the ability of
oligopolists to coordinate pricing.
Large numbers of competitors lead to prices at the cost of production, because higher prices
will be underbid.
Activity 3—Market Structure Article
Type:
Topics:
Class limitations:
Take-home assignment
Market structure
Works in any size of class
Purpose
This assignment integrates several concepts and relates them to a real-world case. Students
can easily find examples of oligopoly, monopoly, or monopolistic competition. Some have
difficulty choosing the appropriate model to analyze their article, particularly for oligopolistic
industries.
Instructions
Ask the students to complete the following assignment:
1. Find an article in a recent newspaper or magazine that illustrates a market structure
other than perfect competition.
2. Is it an example of monopoly, monopolistic competition, or oligopoly?
3. Do you think the firms in the industry are earning an economic profit? Are new firms
likely to enter this market? Why or why not?
4. Turn in a copy of the article along with your explanation.
Chapter 16/Oligopoly ) 323
III.
Game Theory and the Economics of Cooperation
A.
Definition of game theory: the study of how people behave in strategic
situations.
1.
By strategic, we mean a situation in which each person, in deciding what actions
to take, must consider how others might respond to that action.
2.
Each firm in an oligopoly must act strategically, because its profit not only
depends on how much output it produces, but also on how much other firms
produce as well.
B.
Definition of prisoners’ dilemma: a particular “game” between two captured
prisoners that illustrates why cooperation is difficult to maintain even when it
is mutually beneficial.
C.
The Prisoners’ Dilemma
1.
Example: Bonnie and Clyde have been captured. The police have enough
evidence to convict them on a weapons charge (sentence = one year) but
suspect that they have been involved in a bank robbery. Because they lack hard
evidence in the crime, they need at least one of them to confess.
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2.
The police lock the two in separate rooms and offer each of them a deal:
"We can lock you up for one year. However, if you confess to the bank robbery
and implicate your partner, we will give you immunity. You will go free and your
partner will get 20 years in jail. If you both confess, we won’t need your
testimony and avoid the cost of a trial so you will both get an intermediate
sentence of eight years."
3.
The decision for both Bonnie and Clyde can be described using a payoff matrix:
Figure 2
Bonnie’s Decision
Clyde’s
Decision
Confess
Remain Silent
Confess
Bonnie gets 8 years
Clyde gets 8 years
Bonnie gets 20 years
Clyde goes free
Remain
Silent
Bonnie goes free
Clyde gets 20 years
Bonnie gets 1 year
Clyde gets 1 year
4.
Definition of dominant strategy: a strategy that is best for a player in a
game regardless of the strategies chosen by the other players.
5.
Bonnie’s dominant strategy is to confess.
a.
If Clyde remains silent, Bonnie can go free by confessing.
b.
If Clyde confesses, Bonnie can lower her sentence by confessing.
324 ) Chapter 16/Oligopoly
6.
D.
Clyde’s dominant strategy is to confess.
a.
If Bonnie remains silent, Clyde can go free by confessing.
b.
If Bonnie confesses, Clyde can lower his sentence by confessing.
7.
If they had both remained silent, they would have been better off collectively
(with a sentence of only one year instead of eight). But, by each pursuing his or
her own self-interests, the two prisoners together reach an outcome that is
worse for both of them.
8.
Cooperation between the two prisoners is difficult to maintain, because
cooperation is individually irrational.
Oligopolies as a Prisoners’ Dilemma
1.
Example: Jack and Jill are trying to keep the sale of water low to keep the price
high. After reaching an agreement, each person must decide whether to follow
the agreement.
PMG
2.
Suppose that they are faced with the following decision:
Figure 3
Jack’s Decision
Jill’s
Decision
3.
High Production
Low Production
High
Production
$1,600 profit for Jack
$1,600 profit for Jill
$1,500 profit for Jack
$2,000 profit for Jill
Low
Production
$2,000 profit for Jack
$1,500 profit for Jill
$1,800 profit for Jack
$1,800 profit for Jill
The dominant strategy for Jack is to produce at a high rate.
a.
If Jill produces at a high rate, Jack will earn a higher amount of profit if
he too produces at a high rate.
b.
If Jill produces at a low rate, Jack will earn a higher profit if he produces
at a high rate as well.
4.
For the same reasons, the dominant strategy for Jill is to produce at a high rate.
5.
Even though total profit would be highest if both individuals produced at a low
rate, self-interest will encourage them to produce at a high rate.
6.
Case Study: OPEC and the World Oil Market
a.
Much of the world’s oil is produced by a few countries. These countries
have formed a cartel called the Organization of Petroleum Exporting
Countries (OPEC).
Chapter 16/Oligopoly ) 325
E.
b.
OPEC tries to raise the price of its product through a coordinated
reduction in the quantity of oil produced.
c.
Like any oligopoly, the member nations face the dilemma between
cooperation and self-interest.
d.
OPEC was fairly successful in maintaining cooperation and high prices
from 1973 to 1985.
e.
In the early 1980s, member countries began arguing over production
levels.
f.
In recent years, the cartel has been largely unsuccessful at reaching and
enforcing agreements.
Other Examples of the Prisoners’ Dilemma
1.
Arms Race
Figure 4
PMG
a.
The decision matrix could look like this:
Decision of United States (U.S.)
Decision of
Soviet Union
(USSR)
b.
2.
Figure 5
Arm
Disarm
Arm
Disarm
U.S. at risk
USSR at risk
U.S. safe and powerful
USSR at risk and weak
U.S. at risk and weak
USSR safe and powerful
U.S. safe
USSR safe
The dominant strategy for each country in this example is to arm.
Common Resources
a.
The decision matrix could look like this:
Exxon’s Decision
Chevron’s
Decision
Drill two wells
Drill one well
Drill two
wells
$4 million profit for Exxon
$4 million profit for Chevron
$3 million profit for Exxon
$6 million profit for Chevron
Drill one
well
$6 million profit for Exxon
$3 million profit for Chevron
$5 million profit for Exxon
$5 million profit for Chevron
b.
The dominant strategy for both firms will be to drill two wells.
326 ) Chapter 16/Oligopoly
F.
The Prisoners’ Dilemma and the Welfare of Society
1.
2.
G.
In some cases, the noncooperative equilibrium is bad from society’s standpoint.
a.
In the arms race example, both countries end up at risk.
b.
In the common resources game, the extra wells dug are wasteful.
However, in the case of a cartel trying to maintain monopoly profits, the
noncooperative solution is an improvement from the standpoint of society.
Why People Sometimes Cooperate
1.
While cooperation is difficult to maintain, it is not impossible.
2.
Cooperation is easier to enforce if the game is repeated.
3.
Case Study: The Prisoners’ Dilemma Tournament
a.
IV.
Political scientist Robert Axelrod held a tournament in which people
entered by sending computer programs designed to play repeated
prisoners’ dilemma games.
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b.
The winner was the program that received the fewest total years in jail.
c.
The winning strategy, called “tit-for-tat,” occurred where a player would
start out cooperating and then do whatever the other player did during
the previous time period. In other words, the strategy starts out friendly,
penalizes unfriendly players, and then forgives them if warranted.
Public Policy toward Oligopolies
A.
Restraint of Trade and the Antitrust Laws
1.
The Sherman Act of 1890 elevated agreements among oligopolists from an
unenforceable contract to a criminal conspiracy.
2.
The Clayton Act of 1914 strengthened the Sherman Act and allowed individuals
the right to sue to recover three times the damages sustained from an illegal
agreement to restrain trade.
3.
Case Study: An Illegal Phone Call
a.
In the early 1980s, Howard Putnam, the president of Braniff Airways,
taped a telephone call from Robert Crandall, the president of American
Airlines.
b.
In the phone conversation, Crandall suggested to Putnam that they each
raise their fares.
c.
Putnam turned the tape over to the Justice Department, which filed suit
against Crandall.
Chapter 16/Oligopoly ) 327
B.
Controversies over Antitrust Policy
1.
Business practices that appear to reduce competition may in fact have legitimate
purposes.
2.
Resale Price Maintenance
3.
a.
Resale price maintenance (also called “fair trade”) is a restriction by a
manufacturer on the price that sellers can charge for a product, usually
used to keep the price from being lower at one retailer than another.
b.
Economists have argued that this policy has a legitimate goal. Customers
often go to one store with good service, knowledgeable sales people,
and higher prices for information on a product and then buy the product
at a discount superstore. Resale price maintenance limits the
superstore’s ability to "free ride" on the service provided by other
retailers.
Predatory Pricing
a.
When firms with monopoly power are faced with new competition, they
may cut prices drastically to drive the new competition out of business
and restore their monopoly power.
b.
This behavior is called predatory pricing.
c.
Economists doubt whether this strategy is used often, because it would
mean that the monopoly would have to sustain large losses. It is also
difficult to expect that courts are able to determine which price cuts are
competitive and which are predatory.
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4.
5.
Tying
a.
Tying occurs when two products are sold together.
b.
Economists do not believe this to be a problem because people will not
be willing to pay more for two products sold together than they would be
willing to pay for the goods separately. Thus, this practice cannot change
market power.
c.
Instead, tying may simply be a form of price discrimination. Profits may
rise if a firm charges a combined price closer to the buyers’ total
willingness to pay.
Case Study: The Microsoft Case
a.
In 1998, the U.S. Justice Department filed suit against Microsoft
Corporation.
b.
A central issue in the case involved the tying of Microsoft’s Internet
browser to its Windows operating system.
328 ) Chapter 16/Oligopoly
6.
c.
In November 1999, a judge issued a ruling that Microsoft had a great
amount of monopoly power and had illegally abused this power.
d.
In June 2000, the judge ordered that Microsoft be broken up into two
companies, one that sold the operating system and one that sold
applications software. An appeals court overturned the verdict and
handed the case to a new judge.
e.
In September 2001, the Justice Department announced that it no longer
sought a breakup of the company and wanted to settle the case quickly.
A settlement was reached in November 2002.
f.
In recent years, Microsoft has contended with several private antitrust
lawsuits as well as lawsuits brought by the European Union.
In the News: Antitrust in the New Economy
a.
Many of today’s technology-based industries require a large up-front
investment, but face very small marginal costs of production.
b.
This is an article from The Wall Street Journal discussing the antitrust
problems that have to be faced in the new economy.
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SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can be found near the end of the textbook.
1.
2.
Oligopoly is a market structure in which only a few sellers offer similar or identical products.
Examples include the market for tennis balls and the world market for crude oil. Monopolistic
competition is a market structure in which many firms sell products that are similar but not
identical. Examples include the markets for novels, movies, restaurant meals, and computer
games.
If the members of an oligopoly could agree on a total quantity to produce, they would choose to
produce the monopoly quantity, acting in collusion as if they were a monopoly.
If the members of the oligopoly make production decisions individually, self-interest induces them
to produce a greater quantity than the monopoly quantity.
Chapter 16/Oligopoly ) 329
3.
The prisoners’ dilemma is the story of two criminals suspected of committing a crime, in which
the sentence that each receives depends both on his or her decision whether to confess or
remain silent and on the decision made by the other. The following table shows the prisoners’
choices:
Bonnie’s Decision
Confess
Clyde’s
Decision
Confess
Remain
Silent
Bonnie gets eight years
Clyde gets eight years
Bonnie goes free
Clyde gets 20 years
Remain Silent
Bonnie gets 20 years
Clyde goes free
Bonnie gets one year
Clyde gets one year
The likely outcome is that both will confess, since that is a dominant strategy for both.
The prisoners’ dilemma teaches us that oligopolies have trouble maintaining the cooperative
outcome of low production, high prices, and monopoly profits because each oligopolist has an
incentive to cheat.
4.
It is illegal for businesses to make an agreement about reducing output or raising prices.
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Antitrust laws are controversial because some business practices may appear anti-competitive
while in fact having legitimate business purposes. An example is resale price maintenance.
Questions for Review
1.
2.
If a group of sellers could form a cartel, they would try to set quantity and price like a
monopolist. They would set quantity at the point where marginal revenue equals marginal cost,
and set price at the corresponding point on the demand curve.
Firms in an oligopoly produce a quantity of output that is greater than the level produced by
monopoly. They sell the product at a price that is lower than the monopoly price.
3.
Firms in an oligopoly produce a quantity of output that is less than the level produced by a
perfectly competitive market. They sell the product at a price that is greater than the perfectly
competitive price.
4.
As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and
more like a competitive market. The price approaches marginal cost, and the quantity produced
approaches the socially efficient level.
5.
The prisoners’ dilemma is a game between two people or firms that illustrates why it is difficult
for opponents to cooperate even when cooperation would make them all better off. Each person
or firm has a great incentive to cheat on any cooperative agreement to make himself or itself
better off. Thus, firms have a difficult time maintaining a cooperative agreement.
6.
The arms race and common resources are some examples of how the prisoners’ dilemma helps
to explain behavior. In the arms race during the Cold War, the United States and the Soviet
Union could not agree on arms reductions because each was fearful that after cooperating for a
while, the other country would cheat. When two companies share a common resource, they
would be better off sharing it. But, fearful that the other company will use more of the common
resource, each company ends up overusing it.
330 ) Chapter 16/Oligopoly
7.
Antitrust laws prohibit firms from trying to monopolize a market. They are used to prevent
mergers that would lead to excessive market power in any firm and to keep oligopolists from
acting together in ways that would make the market less competitive.
8.
Resale price maintenance occurs when a wholesaler sets a minimum price that retailers can
charge. This might seem to be anticompetitive because it prevents retailers from competing on
price. But that is doubtful because: (1) if the wholesaler has market power, it can exercise such
power through the wholesale price; (2) wholesalers have no incentive to discourage competition
among retailers because doing so reduces the quantity sold; and (3) maintaining a minimum
price may be valuable in that it provides incentives to retailers to provide customers with good
service.
Problems and Applications
1.
2.
3.
a.
Tap water is a perfectly competitive market because there are many taps and the
product does not differ across sellers.
b.
Bottled water is a monopolistically competitive market. There are many sellers of bottled
water, but each firm tries to differentiate its own brand from the rest.
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c.
The cola market is an oligopoly. There are only a few firms that control a large portion of
the market.
d.
The beer market is an oligopoly. There are only a few firms that control a large portion of
the market.
a.
OPEC members were trying to reach an agreement to cut production so they could raise
the price.
b.
They were unable to agree on cutting production because each country has an incentive
to cheat on any agreement. The turmoil is a decline in the price of oil because of
increased production.
c.
OPEC would like Norway and Britain to join their cartel so that they could act as a
monopoly.
a.
If there were many suppliers of diamonds, price would equal marginal cost ($1,000), so
the quantity would be 12,000.
b.
With only one supplier of diamonds, quantity would be set where marginal cost equals
marginal revenue. The following table derives marginal revenue:
Price
(thousands of dollars)
8
7
6
5
4
3
2
1
Quantity
(thousands)
5
6
7
8
9
10
11
12
Total Revenue
(millions of dollars)
40
42
42
40
36
30
22
12
Marginal Revenue
(millions of dollars)
---2
0
–2
–4
–6
–8
–10
Chapter 16/Oligopoly ) 331
With marginal cost of $1,000 per diamond, or $1 million per thousand diamonds, the
monopoly will maximize profits at a price of $7,000 and a quantity of 6,000. Additional
production beyond this point would lead to a situation where marginal revenue is lower
than marginal cost.
4.
5.
c.
If Russia and South Africa formed a cartel, they would set price and quantity like a
monopolist, so the price would be $7,000 and the quantity would be 6,000. If they split
the market evenly, they would share total revenue of $42 million and costs of $6 million,
for a total profit of $36 million. So each would produce 3,000 diamonds and get a profit
of $18 million. If Russia produced 3,000 diamonds and South Africa produced 4,000, the
price would decline to $6,000. South Africa’s revenue would rise to $24 million, costs
would be $4 million, so profits would be $20 million, which is an increase of $2 million.
d.
Cartel agreements are often not successful because one party has a strong incentive to
cheat to make more profit. In this case, each could increase profit by $2 million by
producing an extra 1,000 diamonds. However, if both countries did this, profits would
decline for both of them.
a.
Buyers who are oligopolists try to decrease the prices of goods they buy.
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b.
The owners of baseball teams would like to keep players’ salaries low. This goal is
difficult to achieve because each team has an incentive to cheat on any agreement,
because they will be able to attract better players by offering higher salaries.
c.
The salary cap would have formalized the collusion on salaries and helped to prevent any
team from cheating.
a.
If Mexico imposes low tariffs, then the United States is better off with high tariffs,
because it gets $30 billion with high tariffs and only $25 billion with low tariffs. If Mexico
imposes high tariffs, then the United States is better off with high tariffs, because it gets
$20 billion with high tariffs and only $10 billion with low tariffs. So the United States has
a dominant strategy of high tariffs.
If the United States imposes low tariffs, then Mexico is better off with high tariffs,
because it gets $30 billion with high tariffs and only $25 billion with low tariffs. If the
United States imposes high tariffs, then Mexico is better off with high tariffs, because it
gets $20 billion with high tariffs and only $10 billion with low tariffs. So Mexico has a
dominant strategy of high tariffs.
b.
A Nash equilibrium is a situation in which economic actors interacting with one another
each choose their best strategy given the strategies others have chosen. The Nash
equilibrium in this case is for each country to have high tariffs.
c.
The NAFTA agreement represents cooperation between the two countries. Each country
reduces tariffs and both are better off as a result.
d.
The payoffs in the upper left and lower right parts of the box do reflect a nation’s
welfare. Trade is beneficial and tariffs are a barrier to trade. However, the payoffs in the
upper right and lower left parts of the box are not valid. A tariff hurts domestic
consumers and helps domestic producers, but total surplus declines, as we saw in
Chapter 9. So it would be more accurate for these two areas of the box to show that
332 ) Chapter 16/Oligopoly
both countries’ welfare will decline if they imposed high tariffs, whether or not the other
country had high or low tariffs.
6.
a.
The payoffs are:
Your Decision
Work
Work
You get 15 units of
happiness
Classmate gets 15
units of happiness
You get 30 units of
happiness
Classmate gets 5 units
of happiness
Shirk
You get 5 units of
happiness
Classmate gets 30
units of happiness
You get 10 units of
happiness
Classmate gets 10 units
of happiness
Classmate’s
Decision
b.
Shirk
The likely outcome is that both of you will shirk. If your classmate works, you’re better
off shirking, because you would rather have 30 units of happiness rather than 15. If your
classmate shirks, you are better off shirking because you would rather have 10 units of
happiness rather than 5. So your dominant strategy is to shirk. Your classmate faces the
same payoffs, so he or she will also shirk.
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c.
If you are likely to work with the same person again, you have a greater incentive to
work, so that your classmate will work, and you will both be better off. In repeated
games, cooperation is more likely.
d.
The payoff matrix would become:
Your Decision
Work
Shirk
Work
You get 15 units of
happiness
Classmate gets 65
units of happiness
You get 30 units of
happiness
Classmate gets 25 units
of happiness
Shirk
You get 5 units of
happiness
Classmate gets 50
units of happiness
You get 10 units of
happiness
Classmate gets 10 units
of happiness
Classmate’s
Decision
Work is a dominant strategy for this new classmate. Therefore, the Nash equilibrium will
be for you to shirk and your classmate to work. You would get a B and thus would prefer
this classmate to the first. However, he would prefer someone with a dominant strategy
of working as well so that he could get an A.
Chapter 16/Oligopoly ) 333
7.
a.
The decision box for this game is:
Braniff’s Decision
Low Price
American’s
Decision
b.
High Price
Low
Price
Low profits for Braniff
Low profits for American
Very low profits for Braniff
High Profits for American
High
Price
High profits for Braniff
Very low profits for American
Medium profits for Braniff
Medium profits for American
If Braniff sets a low price, American will set a low price. If Braniff sets a high price,
American will set a low price. So American has a dominant strategy to set a low price.
If American sets a low price, Braniff will set a low price. If American sets a high price,
Braniff will set a low price. So Braniff has a dominant strategy to set a low price.
Because both have a dominant strategy to set a low price, the Nash equilibrium is for
both to set a low price.
8.
c.
A better outcome would be for both airlines to set a high price; they would both get
higher profits. That outcome could only be achieved by cooperation (collusion). If that
happened, consumers would lose because prices would be higher and quantity would be
lower.
a.
If Jones has 10 cows and Smith has 10 for a total of 20 cows, each cow produces $4,000
of milk. Because a cow costs $1,000, profits would be $3,000 per cow, or $30,000 for
each farmer.
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If one farmer had 10 cows and the other farmer had 20 cows for a total of 30 cows, each
cow produces $3,000 of milk. Profits per cow would be $2,000, so the farmer with 10
cows makes $20,000; the farmer with 20 cows makes $40,000.
If both farmers have 20 cows for a total of 40 cows, each cow produces $2,000 of milk.
Profit per cow is $1,000, so each farmer’s profit is $20,000. The results are shown in the
table:
Jones’ Decision
Smith’s
Decision
b.
10 cows
20 cows
10 cows
$30,000 profit for Jones
$30,000 profit for Smith
$40,000 profit for Jones
$20,000 profit for Smith
20 cows
$20,000 profit for Jones
$40,000 profit for Smith
$20,000 profit for Jones
$20,000 profit for Smith
If Jones had 10 cows, Smith would want 20 cows. If Jones had 20 cows, Smith would be
indifferent (get the same profit) if he had 10 or 20 cows. So Smith has a dominant
strategy of having 20 cows.
If Smith had 10 cows, Jones would want 20 cows. If Smith had 20 cows, Jones would be
indifferent (get the same profit) if he had 10 or 20 cows. So Jones has a dominant
strategy of having 20 cows.
334 ) Chapter 16/Oligopoly
The Nash equilibrium is for each farmer to have 20 cows, because that is the dominant
strategy for each. They each make profits of $20,000. But they would both be better off
if they cooperated and each had only 10 cows; then profit would be $30,000 each.
9.
c.
The problem illustrates how a common field may be overused, reducing the profits of
producers. Because people tend to overuse common fields, it is more efficient for people
to own their own portion of the field. Thus, over time, common fields have been divided
up and owned privately.
a.
If Kona enters, Big Brew would want to maintain a high price. If Kona does not enter, Big
Brew would want to maintain a high price. Thus, Big Brew has a dominant strategy of
maintaining a high price.
If Big Brew maintains a high price, Kona would enter. If Big Brew maintains a low price,
Kona would not enter. Kona does not have a dominant strategy.
b.
Because Big Brew has a dominant strategy of maintaining a high price, Kona should
enter.
c.
There is only one Nash equilibrium. Big Brew will maintain a high price and Kona will
enter.
d.
Little Kona should not believe this threat from Big Brew because it is not in Big Brew’s
interest to carry out the threat. If Little Kona enters, Big Brew can set a high price, in
which case it makes $3 million, or Big Brew can set a low price, in which case it makes
$1 million. Thus the threat is an empty one, which Little Kona should ignore; Little Kona
should enter the market.
e.
If the two firms could successfully collude, they would agree that Big Brew would
maintain a high price and Kona would remain out of the market. They could then split a
profit of $7 million.
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10.
Neither player has a dominant strategy in this game. Jeff should hit left if Steve guesses right
and Jeff should hit right if Steve guesses left. Steve should guess left if Jeff hits left and Steve
should guess right if Jeff hits right. Thus, if Jeff stuck with a particular strategy (left or right),
Steve would be able to guess it easily after a few points. A better strategy for Jeff is to randomly
choose whether to hit the ball left or right, sometimes hitting left and other times hitting right.
11.
a.
Using Table 1 in the chapter, if 80 gallons are produced, the price would be $40 and
profit would be $3,200. Divided three ways, John would get $3,200/3 = $1,066.67. Each
seller would sell 80/3 = 26.67 gallons.
b.
If Jack and Jill stick to the agreement, John will benefit from increasing output by 10
units. The price would fall to $30. Jack’s total profit would increase to (36.67)($30) =
$1,100.10.
c.
The Nash equilibrium will be (n+1)/n = 3/4 of the competitive output. Thus, output will
be 90 gallons, which is greater than the output when there were only two sellers. The
price will now be $30.
17
stic Competition
MONOPOLISTIC
COMPETITION
WHAT’S NEW IN THE FOURTH EDITION:
There is a new FYI box that contrasts the views about advertising held by John Kenneth Galbraith and
Frederic Hayek.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
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¾
competition among firms that sell differentiated products.
¾
how the outcomes under monopolistic competition and under perfect competition compare.
¾
the desirability of outcomes in monopolistically competitive markets.
¾
the debate over the effects of advertising.
¾
the debate over the role of brand names.
CONTEXT AND PURPOSE:
Chapter 17 is the final chapter in a five-chapter sequence dealing with firm behavior and the organization
of industry. Chapters 14 and 15 developed the two extreme forms of market structure—competition and
monopoly. The market structure that lies between competition and monopoly is known as imperfect
competition. There are two types of imperfect competition—oligopoly, which was addressed in the
previous chapter, and monopolistic competition, which is the topic of the current chapter. The analysis in
this chapter is again based on the cost curves developed in Chapter 13.
The purpose of Chapter 17 is to address monopolistic competition—a market structure in which
many firms sell products that are similar but not identical. You will recall that oligopoly differs from
perfect competition because there are only a few sellers in the market. Monopolistic competition differs
from perfect competition because each of the many sellers offers a somewhat different product. As a
result, monopolistically competitive firms face a downward-sloping demand curve while competitive firms
face a horizontal demand curve at the market price. Monopolistic competition is extremely common.
335
336 ) Chapter 17/Monopolistic Competition
KEY POINTS:
1. A monopolistically competitive market is characterized by three attributes: many firms, differentiated
products, and free entry.
2. The equilibrium in a monopolistically competitive market differs from that in a perfectly competitive
market in two related ways. First, each firm has excess capacity. That is, it operates on the
downward-sloping portion of the average-total-cost curve. Second, each firm charges a price above
marginal cost.
3. Monopolistic competition does not have all of the desirable properties of perfect competition. There is
the standard deadweight loss of monopoly caused by the markup of price over marginal cost. In
addition, the number of firms (and thus the variety of products) can be too large or too small. In
practice, the ability of policymakers to correct these inefficiencies is limited.
4. The product differentiation inherent in monopolistic competition leads to the use of advertising and
brand names. Critics of advertising and brand names argue that firms use them to take advantage of
consumer irrationality and to reduce competition. Defenders of advertising and brand names argue
that firms use them to inform consumers and to compete more vigorously on price and product
quality.
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CHAPTER OUTLINE:
I.
II.
III.
Definition of monopolistic competition: a market structure in which many firms sell
products that are similar but not identical.
Characteristics of Monopolistic Competition
A.
Many Sellers
B.
Product Differentiation
C.
Free Entry
Competition with Differentiated Products
A.
The Monopolistically Competitive Firm in the Short Run
Figure 1
1.
Each firm in monopolistic competition faces a downward-sloping demand curve
because its product is different from those offered by other firms.
2.
The monopolistically competitive firm follows a monopolist's rule for maximizing
profit.
Chapter 17/Monopolistic Competition ) 337
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Explain to students that product differentiation gives the seller in a monopolistically
competitive market some ability to control the price of its product. In a sense, each
firm is a monopoly in the production of their particular version of the product. This is
reflected by the fact that these firms face a downward-sloping demand curve. Point
out that the graph looks something like a monopoly, but that the demand the firm
faces will likely be much flatter (because it will be more elastic).
3.
B.
a.
It chooses the output level where marginal revenue is equal to marginal
cost.
b.
It sets the price using the demand curve to ensure that consumers will
buy the amount produced.
We can determine whether or not the monopolistically competitive firm is
earning a profit or loss by comparing price and average total cost.
a.
If P > ATC, the firm is earning a profit.
b.
If P < ATC, the firm is earning a loss.
c.
If P = ATC, the firm is earning zero economic profit.
The Long-Run Equilibrium
Figure 2
1.
When firms in monopolistic competition are making profit, new firms have an
incentive to enter the market.
a.
This increases the number of products from which consumers can
choose.
338 ) Chapter 17/Monopolistic Competition
2.
b.
Thus, the demand curve faced by each firm shifts to the left.
c.
As the demand falls, these firms experience declining profit.
When firms in monopolistic competition are incurring losses, firms in the market
will have an incentive to exit.
a.
Consumers will have fewer products from which to choose.
b.
Thus, the demand curve for each firm shifts to the right.
c.
The losses of the remaining firms will fall.
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3.
The process of exit and entry continues until the firms in the market are earning
zero profit.
a.
This means that the demand curve and the average-total-cost curve are
tangent to each other.
b.
At this point, price is equal to average total cost and the firm is earning
zero economic profit.
Remember that students have a hard time understanding why a firm will continue to
operate if it is earning “only” zero economic profit. Remind them that zero economic
profit means that firms are earning an accounting profit equal to their implicit costs.
Point out to students that, just like firms in perfect competition, firms in monopolistic
competition also earn zero economic profit in the long run. Show them that this
result occurs because firms can freely enter the market when profits occur, driving
the level of profits to zero. Any market with no barriers to entry will see zero
economic profit in the long run.
Chapter 17/Monopolistic Competition ) 339
4.
C.
There are two characteristics that describe the long-run equilibrium in a
monopolistically competitive market.
a.
Price exceeds marginal cost (due to the fact that each firm faces a
downward-sloping demand curve).
b.
Price equals average total cost (due to the freedom of entry and exit).
Monopolistic versus Perfect Competition
Figure 3
1.
Excess Capacity
a.
The quantity of output produced by a monopolistically competitive firm is
smaller than the quantity that minimizes average total cost (the efficient
scale).
b.
This implies that firms in monopolistic competition have excess capacity,
because the firm could increase its output and lower its average total
cost of production.
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c.
2.
D.
Because firms in perfect competition produce where price is equal to the
minimum average total cost, firms in perfect competition produce at
their efficient scale.
Markup over Marginal Cost
a.
In monopolistic competition, price is greater than marginal cost because
the firm has some market power.
b.
In perfect competition, price is equal to marginal cost.
Monopolistic Competition and the Welfare of Society
1.
One source of inefficiency is the markup over marginal cost. This implies a
deadweight loss (similar to that caused by monopolies).
2.
Because there are so many firms in this type of market structure, regulating
these firms would be difficult.
3.
Also, forcing these firms to set price equal to marginal cost would force them out
of business (because they are already earning zero economic profit).
4.
There are also externalities associated with entry.
a.
The product-variety externality occurs because as new firms enter,
consumers get some consumer surplus from the introduction of a new
product. Note that this is a positive externality.
340 ) Chapter 17/Monopolistic Competition
5.
IV.
b.
The business-stealing externality occurs because as new firms enter,
other firms lose customers and profit. Note that this is a negative
externality.
c.
Depending on which externality is larger, a monopolistically competitive
market could have too few or too many products.
FYI: Is Excess Capacity a Social Problem?
a.
Monopolistically competitive firms produce at an output level that is
lower than the level that minimizes average total cost.
b.
In the past, economists argued that this excess capacity was a source of
inefficiency.
c.
However, economists today believe that the excess capacity of these
firms is not directly relevant for evaluating economic welfare.
d.
There is no economic reason why society should want all firms to
produce the level of output that minimizes average total cost.
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Advertising
A.
The Debate over Advertising
1.
2.
3.
4.
The Critique of Advertising
a.
Firms advertise to manipulate people's tastes.
b.
Advertising impedes competition because it increases the perception of
product differentiation and fosters brand loyalty. This means that
consumers will be less concerned with price differences among similar
goods.
The Defense of Advertising
a.
Firms use advertising to provide information to consumers.
b.
Advertising fosters competition because it allows consumers to be better
informed about all of the firms in the market.
Case Study: Advertising and the Price of Eyeglasses
a.
In the United States during the 1960s, states differed on whether or not
they allowed advertising for optometrists.
b.
In the states that prohibited advertising, the average price paid for a pair
of eyeglasses in 1963 was $33; in states that allowed advertising, the
average price was $26 (a difference of more than 20%).
FYI: Galbraith versus Hayek
Chapter 17/Monopolistic Competition ) 341
B.
a.
In The Affluent Society (published in 1958), John Kenneth Galbraith
argued that corporations use advertising to create demand for products
that people otherwise do not want or need.
b.
Frederic Hayek wrote a well-known critique of Galbraith in 1961. He
observed that advertising was merely one way in which preferences are
created by the social environment.
Advertising as a Signal of Quality
1.
The willingness of a firm to spend a large amount of money on advertising may
be a signal to consumers about the quality of the product being offered.
2.
Example: Kellogg and Post have each developed a new cereal that would sell for
$3 per box. (Assume that the marginal cost of producing the cereal is zero.) Each
company knows that if it spends $10 million on advertising, it will get one million
new consumers to try the product. If consumers like the product, they will buy it
again.
a.
Post has discovered through market research that its new cereal is not
very good. After buying it once, consumers would not likely buy it again.
Thus, it will only earn $3 million in revenue, which would not be enough
to pay for the advertising. Therefore, it does not advertise.
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3.
b.
Kellogg knows that its cereal is great. Each person that buys it will likely
buy one box per month for the next year. Therefore, its sales would be
$36 million, which is more than enough to justify the advertisement.
c.
By its willingness to spend money on advertising, Kellogg signals to
consumers the quality of its cereal.
Note that the content of the advertisement is unimportant; what is important is
that consumers know that the advertisements are expensive.
Activity 1— Advertising: Informative or Manipulative?
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
Advertising
None
15 minutes
Works in any size class
Purpose
This activity illustrates the various purposes of advertising.
Instructions
Ask students to bring two magazines with them to class on the day that you will discuss this
chapter.
Arrange students into groups of three or four. Their assignment is to determine whether an
advertisement serves primarily to inform consumers and promote competition or make the
consumer less price sensitive to their product.
Ask each group to find an example of both kinds of ads. Make sure that each group is also
responsible for choosing ads for products sold in monopolistically competitive markets.
342 ) Chapter 17/Monopolistic Competition
C.
Brand Names
1.
In many markets there are two types of firms; some firms sell products with
widely recognized brand names while others sell generic substitutes.
2.
Critics of brand names argue that they cause consumers to perceive differences
that do not really exist.
3.
Economists have defended brand names as a useful way to ensure that goods
are of high quality.
a.
Brand names provide consumers with information about quality when
quality cannot be judged easily in advance of purchase.
b.
Brand names give firms an incentive to maintain high quality, because
firms have a financial stake in maintaining the reputation of their brand
names.
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Table 1
Activity 2 — Brand Names
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
Product differentiation
Enough copies of the questions for each student
10 minutes
Works in any size class
Purpose
This activity illustrates the importance of product differentiation in consumer products.
Instructions
Give the students the following quiz. Ask them to make their best guess if they are not certain
about a particular product. Assure them that their grades will not be affected by their scores
on these questions. After they finish, go through the questions product by product, asking the
class to raise their hands if they circled that product.
Common Answers and Points for Discussion
Student answers will be spread across the various brands for each company. All of their
answers are correct. In each case, the company makes every brand listed.
This illustrates the importance of product differentiation in consumer markets. These firms go
to great expense to establish and maintain separate brand identities for products that
essentially serve the same function.
This quiz can be a good way to introduce the effect of product differentiation on demand, or
to introduce the impact of advertising.
Chapter 17/Monopolistic Competition ) 343
Brand Names Quiz
Identify the brands made by each company:
1. Margarine. Unilever makes:
a. Imperial
b. Promise
c. Country Crock
d. Shedd’s
e. Krona
f. Mrs Filbert’s g. I Can’t Believe It’s Not Butter
2. Bottled water. Nestle’ makes:
a. Perrier
b. Arrowhead
d. Calistoga
e. Vittel
c. Poland Spring
f. Contrex
3. Pet Food. Quaker makes:
a. Gravy Train
b. Gaines Burgers
d. Kibbles ‘n Bits e. Top Choice
c. Cycle
f. Ken-L-Ration
4. Soap. Proctor & Gamble makes:
a. Safeguard
b. Zest
c. Ivory
d. Camay
5. Jeans. V.F. Corporation makes:
a. Lee
b. Wrangler
c. Rustler
d. Girbaud
6. Pasta. Borden makes:
a. Creamette
b. Prince
c. Dutch Maid
d. Gioia
c. Bravo
e. Anthony’s
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7. Coffee. Phillip Morris makes:
a. Yuban
b. Maxim
d. Maxwell House
c. Sanka
8. Consumer Electronics. Matsushita makes:
a. Panasonic
b. Technics
c. Quasar
9. Gin. Diageo PLC makes:
a. Gilbey’s
b. Gordon’s
d. National
c. Tanqueray
Activity 3 — Equilibrium Price for Blue Jeans
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Product differentiation
None
5 minutes
Works in any size class
Purpose
This assignment shows that market supply and demand graphs give an oversimplified picture
of price when products are differentiated.
Instructions
Ask the students to draw a supply and demand graph illustrating the market for blue jeans.
After they have drawn the graph, have them label the equilibrium price with a real dollar
figure. This dollar amount should reflect the price of jeans as accurately as possible.
344 ) Chapter 17/Monopolistic Competition
Draw a standard supply and demand graph on the board. Ask a student for the equilibrium
price. Ask several more students for their prices.
Common Answers and Points for Discussion
The class will have a whole range of prices for blue jeans, reflecting the range of blue jeans in
the real world. Recent prices at one shopping mall varied from $14 to over $100 for a pair of
blue jeans.
The price differences reflect product differentiation. Quality, style, and reputation all affect
the price of jeans.
The simple supply and demand diagram can be useful for broad analysis of the market for
jeans, but individual prices and quantities are determined by the demand and cost curves of
the individual products.
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SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
The three key attributes of monopolistic competition are: (1) there are many sellers; (2) each
firm produces a slightly different product; and (3) firms can enter or exit the market freely.
Figure 1 shows the long-run equilibrium in a monopolistically competitive market. This
equilibrium differs from that in a perfectly competitive market because price exceeds marginal
cost and the firm does not produce at the minimum point of average total cost but instead
produces at less than the efficient scale.
Chapter 17/Monopolistic Competition ) 345
Figure 1
2.
Advertising may make markets less competitive if it manipulates people’s tastes rather than being
informative. Advertising may give consumers the perception that there is a greater difference
between two products than really exists. That makes the demand curve for a product more
inelastic, so the firms can then charge greater markups over marginal cost. However, some
advertising could make markets more competitive because it sometimes provides useful
information to consumers, allowing them to take advantage of price differences more easily.
Advertising also facilitates entry because it can be used to inform consumers about a new
product. In addition, expensive advertising can be a signal of quality.
Brand names may be beneficial because they provide information to consumers about the quality
of goods. They also give firms an incentive to maintain high quality, since their reputations are
important. But brand names may be criticized because they may simply differentiate products
that are not really different, as in the case of drugs that are identical with the brand-name drug
selling at a much higher price than the generic drug.
Questions for Review
1.
2.
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The three attributes of monopolistic competition are: (1) there are many sellers; (2) each seller
produces a slightly different product; and (3) firms can enter or exit the market without
restriction. Monopolistic competition is like monopoly because firms face a downward-sloping
demand curve, so price exceeds marginal cost. Monopolistic competition is like perfect
competition because, in the long run, price equals average total cost, as free entry and exit drive
economic profit to zero.
In Figure 2, a firm has demand curve D1 and marginal-revenue curve MR1. The firm is making
profits because at quantity Q1, price (P1) is above average total cost (ATC). Those profits induce
other firms to enter the industry, causing the demand curve to shift to D2 and the marginalrevenue curve to shift to MR2. The result is a decline in quantity to Q2, at which point the price
(P2) equals average total cost (ATC), so profits are now zero.
346 ) Chapter 17/Monopolistic Competition
Figure 2
3.
Figure 3 shows the long-run equilibrium in a monopolistically competitive market. Price equals
average total cost. Price is above marginal cost.
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Figure 3
4.
5.
Because, in equilibrium, price is above marginal cost, a monopolistic competitor produces too
little output. But this is a hard problem to solve because: (1) the administrative burden of
regulating the large number of monopolistically competitive firms would be high; and (2) the
firms are earning zero economic profits, so forcing them to price at marginal cost means that
firms would lose money unless the government subsidized them.
Advertising might reduce economic well-being because it manipulates people's tastes and
impedes competition by making products appear more different than they really are. But
advertising might increase economic well-being by providing useful information to consumers and
fostering competition.
6.
Advertising with no apparent informational content might convey information to consumers if it
provides a signal of quality. A firm will not be willing to spend much money advertising a lowquality good, but may be willing to spend significantly more to advertise a high-quality good.
7.
The two benefits that might arise from the existence of brand names are: (1) brand names
provide consumers information about quality when quality cannot be easily judged in advance;
and (2) brand names give firms an incentive to maintain high quality to maintain the reputation
of their brand names.
Problems and Applications
1.
a.
The market for #2 pencils is perfectly competitive because pencils by any manufacturer
are identical and there are a large number of manufacturers.
b.
The market for copper is perfectly competitive, because all copper is identical and there
are a large number of producers.
Chapter 17/Monopolistic Competition ) 347
2.
3.
4.
c.
The market for local telephone service is monopolistic because it is a natural monopoly—
it is cheaper for one firm to supply all the output.
d.
The market for peanut butter is monopolistically competitive because different brand
names exist with different quality characteristics.
e.
The market for lipstick is monopolistically competitive because lipstick from different
firms differs slightly, but there are a large number of firms that can enter or exit without
restriction.
a.
A firm in monopolistic competition sells a differentiated product from its competitors.
b.
A firm in monopolistic competition has marginal revenue less than price.
c.
Neither a firm in monopolistic competition nor in perfect competition earns economic
profit in the long run.
d.
A firm in perfect competition produces at minimum average total cost in the long run.
e.
Both a firm in monopolistic competition and a firm in perfect competition equate marginal
revenue and marginal cost.
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f.
A firm in monopolistic competition charges a price above marginal cost.
a.
Both a firm in monopolistic competition and a monopoly firm face a downward-sloping
demand curve.
b.
Both a firm in monopolistic competition and a monopoly firm have marginal revenue that
is less than price.
c.
A firm in monopolistic competition faces the entry of new firms selling similar products.
d.
A monopoly firm earns economic profit in the long run.
e.
Both a firm in monopolistic competition and a monopoly firm equate marginal revenue
and marginal cost.
f.
Neither a firm in monopolistic competition nor a monopoly firm produce the socially
efficient quantity of output.
a.
The firm is not maximizing profit. For a firm in monopolistic competition, price is greater
than marginal revenue. If price is below marginal cost, marginal revenue must be less
than marginal cost. Thus, the firm should reduce its output to increase its profit.
b.
The firm may be maximizing profit if marginal revenue is equal to marginal cost.
However, the firm is not in long-run equilibrium because price is less than average total
cost. In this case, firms will exit the industry and the demand facing the remaining firms
will rise until economic profit is zero.
c.
The firm is not maximizing profit. For a firm in monopolistic competition, price is greater
than marginal revenue. If price is equal to marginal cost, marginal revenue must be less
than marginal cost. Thus, the firm should reduce its output to increase its profit.
348 ) Chapter 17/Monopolistic Competition
d.
5.
a.
The firm could be maximizing profit if marginal revenue is equal to marginal cost. The
firm is in long-run equilibrium because price is equal to average total cost. Therefore, the
firm is earning zero economic profit.
Figure 4 illustrates the market for Sparkle toothpaste in long-run equilibrium. The profitmaximizing level of output is QM and the price is PM.
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Figure 4
6.
b.
Sparkle's profit is zero, because at quantity QM, price equals average total cost.
c.
The consumer surplus from the purchase of Sparkle toothpaste is areas A + B. The
efficient level of output occurs where the demand curve intersects the marginal-cost
curve, at QC. The deadweight loss is area C, the area above marginal cost and below
demand, from QM to QC.
d.
If the government forced Sparkle to produce the efficient level of output, the firm would
lose money because average total cost would exceed price, so the firm would shut down.
If that happened, Sparkle's customers would earn no consumer surplus.
By sending Christmas cards to their customers, monopolistically competitive firms are advertising
themselves. Because they are in a position in which price exceeds marginal cost, they would like
to add customers, as shown in Figure 5. Because the price, PM, exceeds marginal cost, MCM, any
additional customer who pays the existing price increases the firm's profits.
Chapter 17/Monopolistic Competition ) 349
Figure 5
7.
a.
A family-owned restaurant would be more likely to advertise than a family-owned farm
because the output of the farm is sold in a perfectly competitive market, in which there is
no reason to advertise, while the output of the restaurant is sold in a monopolistically
competitive market.
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8.
b.
A manufacturer of cars is more likely to advertise than a manufacturer of forklifts
because there is little difference between different brands of industrial products like
forklifts, while there are greater perceived differences between consumer products like
cars. The possible return to advertising is greater in the case of cars than in the case of
forklifts.
c.
A company that invented a very comfortable razor is likely to advertise more than a
company that invented a less comfortable razor that costs the same amount to make
because the company with the very comfortable razor will get many repeat sales over
time to cover the cost of the advertising, while the company with the less comfortable
razor will not.
a.
Perdue created a brand name for chicken by advertising. By doing so, he was able to
differentiate his product from other chicken, gaining market power.
b.
Society gained to the extent that Perdue has a great incentive to maintain the quality of
his chicken. Society lost to the extent that the market for chicken became less
competitive, with the associated deadweight loss.
350 ) Chapter 17/Monopolistic Competition
9.
a.
Figure 6 shows Tylenol's demand, marginal revenue, and marginal cost curves. Tylenol's
price is PT, its marginal cost is MCT, and its markup over marginal cost is PT − MCT.
Figure 6
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b.
Figure 7 shows the demand, marginal revenue, and marginal cost curves for a maker of
acetaminophen. The diagrams differ in that the acetaminophen maker faces a horizontal
demand curve, while the maker of Tylenol faces a downward-sloping demand curve. The
acetaminophen maker has no markup of price over marginal cost, while the maker of
Tylenol has a positive markup, because it has some market power.
Figure 7
c.
The maker of Tylenol has a bigger incentive for careful quality control, because if quality
were poor, the value of its brand name would deteriorate, sales would decline, and its
advertising would be worthless.
8
roduction
18
THE MARKETS FOR THE
FACTORS OF PRODUCTION
WHAT’S NEW IN THE FOURTH EDITION:
There is a new FYI box on the Luddite revolt against new technology in early 19th-century England.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
¾
the labor demand of competitive, profit-maximizing firms.
¾
the household decisions that lie behind labor supply.
¾
why equilibrium wages equal the value of the marginal product of labor.
¾
how the other factors of production—land and capital—are compensated.
¾
how a change in the supply of one factor alters the earnings of all of the factors.
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CONTEXT AND PURPOSE:
Chapter 18 is the first chapter in a three-chapter sequence that addresses the economics of labor
markets. Chapter 18 develops and analyzes the markets for the factors of production—labor, land, and
capital. Chapter 19 builds on Chapter 18 and explains in more detail why some workers earn more than
others do. Chapter 20 addresses the distribution of income and the role the government can play in
altering the distribution of income.
The purpose of Chapter 18 is to provide the basic theory for the analysis of factor markets—the
markets for labor, land, and capital. As you might expect, we find that the wages earned by the factors of
production depend on the supply and demand for the factor. What is new in the analysis is that the
demand for a factor is a derived demand. That is, a firm’s demand for a factor is determined by its
decision to supply a good in another market.
KEY POINTS:
1. The economy’s income is distributed in the markets for the factors of production. The three most
important factors of production are labor, land, and capital.
351
352 ) Chapter 18/The Markets for the Factors of Production
2. The demand for factors, such as labor, is a derived demand that comes from firms that use the
factors to produce goods and services. Competitive, profit-maximizing firms hire each factor up to the
point at which the value of the marginal product of the factor equals its price.
3. The supply of labor arises from individuals’ trade-offs between work and leisure. An upward-sloping
labor supply curve means that people respond to an increase in the wage by enjoying less leisure and
working more hours.
4. The price paid to each factor adjusts to balance the supply and demand for that factor. Because
factor demand reflects the value of the marginal product of that factor, in equilibrium each factor is
compensated according to its marginal contribution to the production of goods and services.
5. Because factors of production are used together, the marginal product of any one factor depends on
the quantities of all factors that are available. As a result, a change in the supply of one factor alters
the equilibrium earnings of all the factors.
CHAPTER OUTLINE:
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Begin this chapter by reviewing how demand and supply determine product prices.
Start by asking, “Why is chicken cheaper than steak?” and “Why are apples cheaper
(per pound) than grapes?” Review the explanations using supply and demand
analysis. Now ask, “Why do airline pilots earn more than school bus drivers?” and
“Why is land on the Boardwalk in Atlantic City more expensive than land 50 miles
southwest of Atlantic City?”
I.
II.
Definition of factors of production: the inputs used to produce goods and services.
A.
The markets for these factors of production are similar to the markets for goods and
services discussed earlier, but they are different in one important way.
B.
The demand for a factor of production is a derived demand, meaning that the firm's
demand for a factor of production is derived from its decision to supply a good in another
market.
The Demand for Labor
In the market for labor, households are the suppliers while firms are the demanders.
You will need to remind students of this because they are used to seeing markets in
which this is reversed.
A.
The wage earned by workers is determined by the supply and demand for workers.
B.
The Competitive Profit-Maximizing Firm
Figure 1
Chapter 18/The Markets for the Factors of Production ) 353
1.
Example: A firm that owns an orchard must decide how many apple pickers to
hire.
2.
Assume that the firm operates in both a competitive output market and a
competitive labor market.
3.
C.
a.
This implies that the firm is a price taker in the apple market, meaning
that it has no control over the price at which it can sell its apples.
b.
The firm is also a price taker in the labor market, meaning that it has no
control over the wage that it must pay its apple pickers.
Assume also that the firm's goal is to maximize profit (total revenue – total cost).
The Production Function and the Marginal Product of Labor
1.
The firm must consider how the quantity of apples it can harvest and sell is
affected by the number of apple pickers hired.
2.
Definition of production function: the relationship between the quantity
of inputs used to make a good and the quantity of output of that good.
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3.
Definition of marginal product of labor: the increase in the amount of
output from an additional unit of labor.
Table 1
VMPL
4.
L
Q
MPL
(= P x MPL)
W
Marginal
Profit
0
0
----
----
----
----
1
100
100
$1,000
$500
$500
2
180
80
800
500
300
3
240
60
600
500
100
4
280
40
400
500
–100
5
300
20
200
500
–300
Definition of diminishing marginal product: the property whereby the
marginal product of an input declines as the quantity of the input
increases.
Figure 2
D.
The Value of Marginal Product and the Demand for Labor
1.
When deciding how many workers to hire, the firm considers how much profit
each worker would bring in.
2.
Because profit equals total revenue minus total cost, the profit from an additional
worker is the worker's contribution to revenue minus the worker's wage.
354 ) Chapter 18/The Markets for the Factors of Production
3.
Definition of value of the marginal product: the marginal product of an
input times the price of the output.
VMPL = P × MPL
a.
Economists sometimes refer to the value of marginal product as the
firm’s marginal revenue product.
b.
The value of the marginal product is the extra revenue a firm gets from
hiring an additional unit of a factor of production.
ALTERNATIVE CLASSROOM EXAMPLE:
Binkle, Inc. produces and sells bottles in a perfectly competitive market at a price of $0.50.
Binkle hires its labor in a perfectly competitive labor market at an hourly wage of $20. The
relationship between the quantity of labor hired and the amount of output produced per hour
is presented in the following table:
L
Q
MPL
VMPL
(= P x MPL)
W
Marginal Profit
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4.
5.
0
0
----
----
----
----
1
90
90
$45
$20
$25
2
170
80
40
20
20
3
240
70
35
20
15
4
300
60
30
20
10
5
350
50
25
20
5
6
390
40
20
20
0
7
420
30
15
20
–5
8
440
20
10
20
–10
If the wage for workers is $500 per week, the firm will only hire three workers.
a.
For the first three workers, the value of the marginal product is greater
than the wage, so the marginal profit from hiring these workers is
positive.
b.
For the fourth worker, the value of the marginal product is lower than
the wage, so the marginal profit from hiring this worker would be
negative.
We can show the firm's decision graphically.
Figure 3
a.
The value of the marginal product curve will slope downward because of
the diminishing marginal product of labor.
Chapter 18/The Markets for the Factors of Production ) 355
b.
6.
The wage is depicted by a horizontal line because the firm is a price
taker in the labor market.
A competitive, profit-maximizing firm hires workers up to the point where the
value of the marginal product of labor is equal to the wage.
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7.
Because the firm chooses the quantity of labor at which the value of the
marginal product equals the wage, the value-of-marginal-product curve is the
firm's labor demand curve.
Emphasize that because the value of the marginal product involves both the marginal
product and the price of the good, any change in these two elements will lead to a
change in the demand for labor.
E.
FYI: Input Demand and Output Supply: Two Sides of the Same Coin
1.
If W is the wage and an extra unit of labor produces MPL units of output, then
the marginal cost of a unit of output is MC = W/MPL.
2.
A profit-maximizing firm chooses the quantity of labor so that the value of the
marginal product (P x MPL) is equal to the wage (W):
P x MPL = W.
Divide both sides by MPL to get:
P = W/MPL.
Because W/MPL = MC, we have:
P = MC.
Students will probably not appreciate how important this is. For that reason, make
sure that you go through it slowly.
356 ) Chapter 18/The Markets for the Factors of Production
3.
F.
When a competitive firm hires labor up to the point at which the value of the
marginal product is equal to the wage, it also produces a level of output at which
price equals marginal cost.
What Causes the Labor Demand Curve to Shift?
1.
2.
The Output Price
a.
An increase in the price of the product raises the value of the marginal
product of labor and therefore increases the demand for labor.
b.
A decrease in the price of the product lowers the value of the marginal
product of labor and therefore decreases the demand for labor.
Technological Change
a.
b.
Technological advance raises the marginal product of labor, which in
turn raises the value of the marginal product of labor.
It is also possible for technological change to reduce labor demand. A
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labor-saving technological change (such as an industrial robot) could
reduce the marginal product of labor and thus the value of the marginal
product of labor.
c.
History suggests that most technological progress has been labor
augmenting.
d.
FYI: The Luddite Revolt – This box describes the 19th-century revolt
against technology that occurred in England. After reading this, students
will understand why we use the term “Luddite” to refer to anyone who
opposes technological progress.
3.
III.
The Supply of Other Factors
a.
The quantity available of one factor can affect the marginal product of
another.
b.
Therefore, any change in the availability of another factor will likely
affect the demand for labor.
The Supply of Labor
A.
The Trade-off between Work and Leisure
1.
Any hours spent working are hours that could be devoted to something else like
studying or watching television. Economists refer to all time not spent working
for pay as “leisure.”
2.
The opportunity cost of an hour of leisure is the amount of money that would
have been earned if that hour were spent at work.
3.
Therefore, as the wage increases, so does the opportunity cost of leisure.
Chapter 18/The Markets for the Factors of Production ) 357
4.
B.
IV.
The labor supply curve shows how individuals respond to changes in the wage in
terms of the labor–leisure trade-off.
a.
An upward-sloping labor supply curve means that an increase in the
wage induces workers to increase the quantity of labor they supply.
b.
Note that, for some individuals, the labor supply curve may in fact be
backward bending. This possibility is discussed in more detail in Chapter
21.
What Causes the Labor Supply Curve to Shift?
1.
Changes in Tastes (for leisure vs. working)
2.
Changes in Alternative Opportunities (other occupations)
3.
Immigration
Equilibrium in the Labor Market
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Figure 4
A.
Marginal Product in Equilibrium
1.
The wage adjusts to balance the supply and demand for labor.
2.
The wage equals the value of the marginal product of labor.
3.
At the labor market equilibrium, each firm has bought as much labor as it finds
profitable at the equilibrium wage.
4.
Thus, any event that changes the supply or demand for labor must change the
equilibrium wage and the value of the marginal product by the same amount,
because these must always be equal.
Go through each of these shifts carefully with the class. Make sure that they see the
relationship between the change in the equilibrium wage and the change in the value
of the marginal product of labor.
B.
Shifts in Labor Supply
Figure 5
1.
An increase in the supply of labor would shift the supply curve to the right,
creating a surplus of workers at the original wage. This will put downward
pressure on the equilibrium wage, causing the quantity of labor demanded to
rise.
a.
As the number of workers employed rises, the marginal product of labor
falls due to the diminishing marginal product of labor.
358 ) Chapter 18/The Markets for the Factors of Production
b.
2.
C.
Thus, both the wage and the value of the marginal product of labor are
now lower.
A decrease in the supply of labor would shift the supply curve to the left,
creating a shortage of workers at the original wage. This will put upward
pressure on the equilibrium wage, causing the quantity of labor demanded to
fall.
a.
As the number of workers employed falls, the marginal product of labor
rises due to the diminishing marginal product of labor.
b.
Thus, both the wage and the value of the marginal product of labor are
now higher.
Shifts in Labor Demand
Figure 6
1.
An increase in the demand for labor will shift the labor demand curve to the
right, creating a shortage at the original wage. This will put upward pressure on
the equilibrium wage causing the quantity of labor supplied to increase.
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2.
D.
a.
The value of the marginal product rises because VMPL = P x MPL (and
either P or MPL have risen to cause the demand for labor to rise).
b.
This implies that both the wage and the value of the marginal product
are now higher.
A decrease in the demand for labor will shift the labor demand curve to the left,
creating a surplus at the original wage. This will put downward pressure on the
equilibrium wage causing the quantity of labor supplied to decrease.
a.
The value of the marginal product falls because VMPL = P x MPL (and
either P or MPL have fallen to cause the demand for labor to decline).
b.
This implies that both the wage and the value of the marginal product
are now lower.
Case Study: Productivity and Wages
1.
Principle #7: Our standard of living depends on our ability to produce goods and
services.
2.
This means that highly productive workers are highly paid, and less productive
workers are less highly paid.
3.
Table 2 shows data on the growth rates of both productivity and wages in the
United States from 1959 to 2003.
Table 2
a.
From 1959 to 2003, productivity grew by about 2.1% per year.
Chapter 18/The Markets for the Factors of Production ) 359
b.
E.
From 1973 to 1995, the growth in productivity was slow compared to the
period before 1973 or the period since 1995.
FYI: Monopsony
1.
Example: the labor market in a small town dominated by a single large employer.
2.
This type of labor market is called a monopsony.
3.
A monopsony firm hires fewer workers than a competitive labor market and pays
a lower wage.
Compare the difference in outcomes between perfect competition and monopoly in
output markets with the differences between perfect competition and monopsony in
labor markets.
V.
The Other Factors of Production: Land and Capital
A.
Definition of capital: the equipment and structures used to produce goods and
services.
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B.
Equilibrium in the Markets for Land and Capital
Figure 7
C.
1.
The purchase price of land or capital is the price paid to own that factor of
production indefinitely.
2.
The rental price of land or capital is the price paid to use that factor for a limited
amount of time.
3.
Because the wage is simply the rental price of labor, what we know about wage
determination also applies to the rental prices of land and capital.
a.
The rental price of land is determined by the supply and demand for
land; the rental price of capital is determined by the supply and demand
for capital.
b.
For both land and capital, the firm increases the quantity hired until the
value of the factor's marginal product equals the factor's rental price.
4.
As long as the firms using the factors of production are competitive and profit
maximizing, land, labor, and capital each earn the value of their marginal
contribution to the production process.
5.
The purchase price of land and capital depend on the current value of the
marginal product and the expected future value of the marginal product.
FYI: What Is Capital Income?
1.
The measurement of capital income is less obvious than the measurement of
labor income.
360 ) Chapter 18/The Markets for the Factors of Production
D.
2.
Capital income is the rent that households receive for the use of their capital.
3.
Some of the earnings from capital are paid to households in the form of interest
or dividends.
4.
Also, some of the earnings from capital may be retained by the firm for future
purchases of capital.
Linkages among the Factors of Production
1.
In most situations, factors of production are used together in a way that makes
the productivity of each factor dependent on the quantities of the other factors
available to be used in the production process.
2.
This means that a change in the supply of any one factor can change the
earnings of all of the factors.
3.
The change in the earnings of any factor can be found by measuring the impact
of the event on the value of the marginal product of that factor.
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4.
Case Study: The Economics of the Black Death
a.
In 14th-century Europe, the bubonic plague killed about one-third of the
population within a few years.
b.
With a smaller supply of workers, we would expect that the wages paid
to workers would rise. This occurs because of diminishing marginal
returns: As the number of workers employed falls, the marginal product
of labor rises. Thus, the value of the marginal product of labor rises.
c.
With fewer workers available to work the land, each additional unit of
land was able to produce less additional output. Thus, the marginal
product of land fell. Because this would lead to a decrease in the value
of the marginal product of land as well, we would expect the rental price
on land to fall.
d.
History shows that our predictions are correct: Wages doubled during
the period and rents declined by 50%.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
The marginal product of labor is the increase in the amount of output from an additional unit of
labor. The value of the marginal product of labor is the marginal product of labor times the price
of the output.
A competitive, profit-maximizing firm decides how many workers to hire by hiring workers up to
Chapter 18/The Markets for the Factors of Production ) 361
the point where the value of the marginal product of labor equals the wage.
2.
A brain surgeon has a higher opportunity cost of enjoying leisure than a janitor because the
surgeon’s wage is so much higher. That is why doctors work such long hours⎯because leisure is
very expensive for them.
3.
An immigration of workers increases labor supply but has no effect on labor demand. The result
is an increase in the equilibrium quantity of labor and a decline in the equilibrium wage, as
shown in Figure 1. The decline in the equilibrium wage causes the quantity of labor demanded
to increase. The increase in the equilibrium quantity of labor causes the marginal product of
labor to decrease.
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Figure 1
4.
The income of the owners of land and capital is determined by the value of the marginal
contribution of land and capital to the production process.
An increase in the quantity of capital would reduce the marginal product of capital, thus reducing
the incomes of those who already own capital. However, it would increase the incomes of
workers because a higher capital stock raises the marginal product of labor.
Questions for Review
1.
A firm's production function describes the relationship between the quantity of labor used in
production and the quantity of output from production. The marginal product of labor is the
increase in the amount of output from an additional unit of labor. Thus, the marginal product of
labor depends directly on the production function. The value of the marginal product of labor is
the marginal product of labor multiplied by the market price of the output.
A competitive, profit-maximizing firm hires workers up to the point where the value of the
marginal product of labor equals the wage. As a result, the value-of-marginal-product curve is
the firm’s labor-demand curve.
2.
Events that could shift the demand for labor include changes in the output price, technological
362 ) Chapter 18/The Markets for the Factors of Production
change, and changes in the supply of other factors.
3.
Events that could shift the supply of labor include changes in tastes, changes in alternative
opportunities, and immigration.
4.
The wage can adjust to balance the supply and demand for labor while simultaneously equaling
the value of the marginal product of labor. Supply and demand for labor determine the
equilibrium wage. Firms maximize profits by choosing the amount of labor where the wage is
equal to the value of the marginal product of labor.
5.
A large immigration would increase the supply of labor, thus reducing the wage. With more labor
working with capital and land, the marginal product of capital and land is higher, so rents earned
by owners of land and capital would increase.
Problems and Applications
1.
a.
The law requiring people to eat one apple a day increases the demand for apples. As
shown in Figure 2, demand shifts from D1 to D2, increasing the price from P1 to P2, and
increasing quantity from Q1 to Q2.
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Figure 2
b.
Because the price of apples increases, the value of marginal product increases for any
given quantity of labor. There is no change in the marginal product of labor for any given
quantity of labor. However, firms will choose to hire more workers and thus the marginal
product of labor at the profit-maximizing level of labor will be lower.
Chapter 18/The Markets for the Factors of Production ) 363
c.
As Figure 3 shows, the increase in the value of marginal product of labor shifts the
demand curve of labor from D1 to D2. The equilibrium quantity of labor rises from L1 to
L2, and the wage rises from w1 to w2.
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Figure 3
2.
a.
If Congress were to buy personal computers for all U.S. college students, the demand for
computers would increase, raising the price of computers and thus increasing the value
of marginal product of workers who produce computers. This is shown in Figure 4 as a
shift in the demand curve for labor from D1 to D2. The result is an increase in the wage
from w1 to w2 and an increase in the quantity of labor from L1 to L2.
Figure 4
b.
If more college students major in engineering and computer science, the supply of labor
in the computer industry rises. This is shown in Figure 5 as a shift in the supply curve
364 ) Chapter 18/The Markets for the Factors of Production
from S1 to S2. The result is a decrease in the wage from w1 to w2 and an increase in the
quantity of labor from L1 to L2.
Figure 5
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c.
If computer firms build new manufacturing plants, this increases the marginal product of
labor and the value of the marginal product of labor for any given quantity of labor. This
is shown in Figure 6 as a shift in the demand curve for labor from D1 to D2. The result is
an increase in the wage from w1 to w2 and an increase in the quantity of labor from L1 to
L2.
Figure 6
Chapter 18/The Markets for the Factors of Production ) 365
3.
a.
The marginal product of labor is equal to the additional output produced by an additional
unit of labor. The table below shows the marginal product of labor (MPL) for this firm:
Days of Labor
0
1
2
3
4
5
6
7
Units of Output
0
7
13
19
25
28
29
29
MPL
VMPL
-6
6
6
6
3
1
0
-60
60
60
60
30
10
0
b.
The value of the marginal product of labor (VMPL) is equal to the price multiplied by the
marginal product of labor (MPL). It is also reported in the table.
c.
The labor demand schedule for the firm is:
Wage
$0
10
30
60
60
60
60
Quantity of Labor Demanded
7
6
5
4
3
2
1
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d.
The labor demand curve is the same as the value-of-the-marginal-product curve. It is
shown in Figure 7.
Wage
60
50
Demand for Labor
40
30
20
10
1
2
3
4
5
6
7 Quantity
of Labor
(days)
Figure 7
e.
If the price of the output rises to $12, the demand for labor will shift to the right because
the value of the marginal product will be higher at each level of labor hired.
366 ) Chapter 18/The Markets for the Factors of Production
4.
Because your uncle is maximizing his profit, he must be hiring workers such that their wage
equals the value of their marginal product. Because the wage is $6 per hour, their value of
marginal product must be $6 per hour. Because the value of marginal product equals the
marginal product times the price of the good and because the price of a sandwich is $3, the
marginal product of a worker must be two sandwiches per hour.
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Figure 8
5.
6.
7.
Figure 9
Technological advance increases the marginal product of workers who have computer skills and
decreases the marginal product of workers who do not have such skills. In these labor markets,
the increased marginal product of workers with computer skills shifts the demand for these
workers to the right (Figure 8), while the demand for workers without computer skills shifts to
the left (Figure 9). The result is an increase in wages for those with computer skills and a
decrease in wages for those without such skills.
a.
When a freeze destroys part of the Florida orange crop, the supply of oranges declines,
so the price of oranges rises. Because there are fewer oranges in a given area of orange
trees, the marginal product of orange pickers declines. The value of the marginal product
of orange pickers could rise or fall, depending on whether the marginal product falls
more or less than the price rises. Thus, you cannot say whether the demand for orange
pickers will rise or fall.
b.
If the price of oranges doubles and the marginal product of orange pickers falls by just
30%, the value of marginal product for a particular quantity of orange pickers increases,
shifting the demand for orange pickers to the right, and increasing the equilibrium wage
of orange pickers.
c.
If the price of oranges rises by 30% and the marginal product of orange pickers falls by
50%, the value of marginal product for a particular quantity of orange pickers decreases,
shifting the demand for orange pickers to the left, and reducing the equilibrium wage of
orange pickers.
a.
Figure 10 shows the U.S. capital market when there is an inflow of capital from abroad.
The inflow of capital shifts the supply curve to the right, from S1 to S2. The result is a
Chapter 18/The Markets for the Factors of Production ) 367
reduction in the rental rate on capital from r1 to r2 and an increase in the quantity of
capital from K1 to K2.
Figure 10
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b.
The increase in capital increases the marginal product of labor and the value of marginal
product of labor for any given quantity of labor. Figure 11 shows this as a shift in the
demand for labor from D1 to D2. As a result, the wage rate rises from w1 to w2 and the
quantity of labor rises from L1 to L2.
Figure 11
368 ) Chapter 18/The Markets for the Factors of Production
8.
a.
If a firm already gives workers fringe benefits valued at more than $3, the new law would
have no effect. But a firm that currently has fringe benefits less than $3 would be affected
by the law. Imagine a firm that currently pays no fringe benefits at all. The requirement
that it pay fringe benefits of $3 reduces the value of marginal product of labor effectively
by $3 in terms of the cash wage the firm is willing to pay. This is shown in Figure 12 as a
downward shift in the firm's demand for labor from D1 to D2, a shift down of exactly $3.
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Figure 12
b.
Because the supply curve has a positive but finite slope, the new equilibrium will be one
in which the new wage, w2, is less than the old wage, w1, but w2 > w1 − $3. The
quantity of labor also declines.
c.
The preceding analysis is incomplete, of course, because it ignores the fact that the
fringe benefits are valuable to workers. As a result, the supply curve of labor might
increase, shown as a shift to the right in the supply of labor in Figure 13. In general,
workers would prefer cash to specific benefits, so the mandated fringe benefits are not
worth as much as cash would be. But in the case of fringe benefits there are two
offsetting advantages: (1) fringe benefits are not taxed; and (2) firms offer cheaper
provision of health care than workers could purchase on their own. Thus, whether the
fringe benefits are worth more or less than $3 depends on which of these effects
dominates.
Chapter 18/The Markets for the Factors of Production ) 369
Figure 13
Figure 13 is drawn under the assumption that the fringe benefits are worth more than $3
to the workers. In this case, the new wage, w2, is less than w1 − $3 and the quantity of
labor increases from L1 to L2.
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If the shift in the supply curve were the same as the shift in the demand curve, then w2
= w1 − $3 and the quantity of labor remains unchanged.
If the shift in the supply curve were less than the shift in the demand curve, then w2 >
w1 − $3 and the quantity of labor decreases.
In all three cases, there is a lower wage and higher quantity of labor than if the supply
curve were unchanged.
9.
d.
Because a minimum-wage law would not allow the wage to decline when greater fringe
benefits are mandated, it would lead to increased unemployment, because firms would
refuse to pay workers more than the value of their marginal product.
a.
A union is like a monopoly firm in that it is the only supplier of labor, just as a monopoly
is the only supplier of a good or service.
b.
Just as a monopoly firm wants to maximize profits, a labor union may wish to maximize
the labor income of its members.
c.
Just as the monopoly price exceeds the competitive price in the market for a good, the
union wage exceeds the free-market wage in the market for labor. Also, the quantity of
output of a monopoly is less than the quantity produced by a competitive industry; this
means that employment by a unionized firm will be lower than employment by a nonunionized firm, because the union wage is higher.
d.
Unions might wish to maximize total labor income of their members, or they might want
the highest wage possible, or they might wish to have the greatest employment possible.
In addition, they may wish to have improved working conditions, increased fringe
benefits, or some input into the decisions made by a firm’s management.
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mination
19
EARNINGS AND
DISCRIMINATION
WHAT’S NEW IN THE FOURTH EDITION:
There is a new In the News box on “The Loss of Manufacturing Jobs.” There is also a new Case Study on
the effects of an individual’s name on his or her labor market opportunities.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
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¾
how wages compensate for differences in job characteristics.
¾
the human-capital and signaling theories of education.
¾
why in some occupations a few superstars earn tremendous incomes in some occupations.
¾
why wages rise above the level that balances supply and demand.
¾
why it is difficult to measure the impact of discrimination on wages.
¾
when market forces can and cannot provide a natural remedy for discrimination.
LEARNING OBJECTIVES:
Chapter 19 is the second chapter in a three-chapter sequence that addresses the economics of labor
markets. Chapter 18 developed the markets for the factors of production. Chapter 19 goes beyond the
supply-and-demand models developed in Chapter 18 to help explain the wide variation in wages we find
in the economy. Chapter 20 addresses the distribution of income and the role the government can play in
altering the distribution of income.
The purpose of Chapter 19 is to extend the basic neoclassical theory of the labor market that was
developed in Chapter 18. Neoclassical theory argues that wages depend on the supply and demand for
labor and that labor demand depends on the value of the marginal productivity of labor. To address the
wide variation in the wages that occurs in the real world, it is important to examine more precisely what
determines the supply and demand for various types of labor.
371
372 ) Chapter 19/Earnings and Discrimination
KEY POINTS:
1. Workers earn different wages for many reasons. To some extent, wage differentials compensate
workers for job attributes. Other things being equal, workers in hard, unpleasant jobs get paid more
than workers in easy, pleasant jobs do.
2. Workers with more human capital get paid more than workers with less human capital. The return to
accumulating human capital is high and has increased over the past decade.
3. Although years of education, experience, and job characteristics affect earnings as theory predicts,
there is much variation in earnings that cannot be explained by things that economists can measure.
The unexplained variation in earnings is largely attributable to natural ability, effort, and chance.
4. Some economists have suggested that more-educated workers earn higher wages not because
education raises productivity but because workers with high natural ability use education as a way to
signal their high ability to employers. If this signaling theory were correct, then increasing the
educational attainment of all workers would not raise the overall level of wages.
5. Wages are sometimes pushed above the level that brings supply and demand into balance. Three
reasons for above-equilibrium wages are minimum-wage laws, unions, and efficiency wages.
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6. Some differences in earnings are attributable to discrimination on the basis of race, sex, or other
factors. Measuring the amount of discrimination is difficult, however, because one must correct for
differences in human capital and job characteristics.
7. Competitive markets tend to limit the impact of discrimination on wages. If the wages of a group of
workers are lower than those of another group for reasons not related to marginal productivity, then
nondiscriminatory firms will be more profitable than discriminatory firms will. Profit-maximizing
behavior, therefore, can act to reduce discriminatory wage differentials. Discrimination can persist in
competitive markets if customers are willing to pay more to discriminatory firms or if the government
passes laws requiring firms to discriminate.
CHAPTER OUTLINE:
I.
Some Determinants of Equilibrium Wages
Most people (especially college students) have little idea about the level of earnings
in the labor force and about the extent of income differences. The general impression
is that earnings are higher than they actually are. Thus, the actual differences in
earnings among the population are a topic that most students will find interesting.
A.
Compensating Differentials
1.
Definition of compensating differential: a difference in wages that arises
to offset the nonmonetary characteristics of different jobs.
Chapter 19/Earnings and Discrimination ) 373
2.
Jobs that are easy, fun, or safe will pay lower wages than jobs that are difficult,
dull, or dangerous.
An obvious example of a compensating wage differential is work that entails danger
and potential personal injury. A wage premium is paid to compensate workers for
exposing themselves to risk. Examples include workers in high-rise construction or
electrical linemen.
B.
Human Capital
1.
Definition of human capital: the accumulation of investments in people,
such as education and on-the-job training.
2.
Workers with more human capital on average earn more than those with less
human capital.
3.
Firms are willing to pay more for highly educated workers because highly
educated workers have higher marginal products.
4.
Case Study: The Increasing Value of Skills
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Table 1
5.
C.
a.
Table 1 compares the average earnings of college graduates with the
average earnings of high school graduates with no additional education.
b.
We can see that there has been an increase in this difference over time.
c.
One possible reason that this has occurred is that international trade has
changed the relative demand for skilled and unskilled labor.
d.
Another possible reason is that changes in technology have changed the
relative demand for skilled and unskilled workers.
In the News: The Loss of Manufacturing Jobs
a.
In the early 1940s, about one in three Americans worked in
manufacturing. Today, that figure is one in ten.
b.
This is an article by former Secretary of Labor Robert Reich that argues
that the loss of these manufacturing jobs is not problematic as long as
the United States increases the level of education of its labor force.
Ability, Effort, and Chance
1.
Because of heredity and upbringing, people differ in their physical and mental
attributes. This will affect their productivity level and therefore their wage.
2.
People also differ in their level of effort. Those who work hard are more
productive and earn a higher wage.
3.
Chance also plays a role in determining wages.
4.
Case Study: The Benefits of Beauty
374 ) Chapter 19/Earnings and Discrimination
D.
a.
Daniel Hamermesh and Jeff Biddle used data from surveys conducted in
the United States and Canada to try to determine how wages are
affected by physical appearance.
b.
They found that people who are considered to be more attractive than
average earned 5% more than people of average looks. People of
average looks earn 5% to 10% more than people considered to be less
attractive than average.
c.
One possible reason for this is that good looks are important for workers
who have close dealings with the public.
d.
Another possible reason is that a person who is successful in making him
or herself attractive may be equally successful in other tasks.
e.
A third possible reason for this difference in the wages is discrimination.
An Alternative View of Education: Signaling
1.
Some economists have suggested that firms may use education as a way to sort
high-ability workers from low-ability workers.
2.
This implies that when people earn a college degree, they do not become more
productive, but instead signal their high ability to prospective employers.
3.
This occurs because it is easier for high-ability people to get college degrees;
therefore, more high-ability people get college degrees.
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E.
In the News: Are Elite Colleges Worth the Cost?
1.
It is often believed that students who attend more selective colleges end up with
higher paying jobs.
2.
A study conducted by Alan Krueger and Stacy Dale indicates that this result is
likely due to selection bias.
3.
F.
a.
Students who are accepted to these schools already have higher
earnings potential.
b.
Comparisons need to be limited to students who were accepted at
comparable institutions.
Students from lower-income families were found to have benefited from
attending selective schools.
The Superstar Phenomenon
1.
Superstars arise in markets that have two characteristics.
a.
Every customer in the market wants to enjoy the good supplied by the
best producer.
Chapter 19/Earnings and Discrimination ) 375
b.
2.
G.
This is why we see superstars in some markets (entertainment, professional
sports) and not in others (plumbing, carpentry).
Above-Equilibrium Wages: Minimum-Wage Laws, Unions, and Efficiency Wages
1.
For some workers, wages are set above the level that brings supply and demand
into balance.
2.
There are three reasons why this may be the case.
a.
Minimum-wage laws that generally apply to the least skilled and least
experienced workers.
b.
Definition of union: a worker association that bargains with
employers over wages and working conditions.
c.
Definition of strike: the organized withdrawal of labor from a firm
by a union.
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3.
II.
The good is produced with a technology that makes it possible for the
best producer to supply every customer at a low cost.
d.
Definition of efficiency wages: above-equilibrium wages paid by
firms to increase worker productivity.
e.
These higher wages often reduce worker turnover, increase worker
effort, and raise the quality of workers who apply for jobs at the firm.
Above-equilibrium wages raise the quantity of labor supplied and lower the
quantity demanded, creating a surplus of labor.
The Economics of Discrimination
A.
Definition of discrimination: the offering of different opportunities to similar
individuals who differ only by race, ethnic group, sex, age, or other personal
characteristics.
B.
Measuring Labor-Market Discrimination
1.
Table 2
Table 2 reports median annual earnings by race and gender for 2003.
a.
The median black man was paid 22% less than the median white man
was.
b.
The median black woman was paid 13% less than the median white
woman was.
c.
The median white woman was paid 24% less than the median white
man was.
d.
The median black woman was paid 16% less than the median black man
was.
376 ) Chapter 19/Earnings and Discrimination
2.
However, it is difficult to determine how much of the differential in wages across
different groups can be attributed to discrimination.
a.
For example, the quantity of education often differs between blacks and
whites.
b.
It is also likely that the quality of education may differ as well.
c.
Women generally have less labor market experience than men.
d.
It may also be true that women take more pleasant jobs than men,
leading to a compensating wage differential.
3.
Because the differences in median earnings among groups in part reflect
differences in human capital and job characteristics, they do not by themselves
say anything about how much discrimination there is in the labor market.
4.
FYI: Is Emily More Employable than Lakisha?
a.
Economists Marianne Bertrand and Sendhil Mullainatham answered more
than 1,300 help-wanted ads run in Boston and Chicago newspapers by
sending in nearly 5,000 fake resumes.
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C.
b.
Half of the resumes had names that were common in the AfricanAmerican community, while the other half had names that were more
common among the white population. Otherwise, the resumes were
similar.
c.
Job applicants with “white” names received about 50% more calls from
interested employers than applicants with “African-American” names.
Discrimination by Employers
1.
It may be incorrect to blame employers for discrimination because each firm has
a profit motive.
2.
Example: Two types of people, blondes and brunettes. Both groups have the
same skills, experience, and work ethic. But employers prefer not to hire
blondes.
3.
a.
This implies that the demand for blondes is lower than it otherwise
would be.
b.
This also means that blondes will earn a lower wage than brunettes.
In this economy, there is an easy way for a firm to beat out its competitors: hire
all blondes.
a.
This firm would pay lower wages and therefore have lower costs.
b.
Over time, we would expect more firms to follow this example.
Chapter 19/Earnings and Discrimination ) 377
D.
c.
The existing firms still hiring brunettes would be forced out of business
due to their higher labor costs.
d.
The demand for blondes increases (increasing the wage that blondes
earn), while the demand for brunettes falls (decreasing the wage that
brunettes earn). This will continue until the wages of the two groups are
equal.
4.
Businesses that care about earning a profit are at an advantage when competing
against those that also care about discriminating.
5.
Case Study: Segregated Streetcars and the Profit Motive
a.
Studies of the streetcar industry suggest that streetcars were never
segregated until the firms were required to do so by law.
b.
In fact, many firms that ran the streetcars protested these laws because
of the increase in the firms' costs from the law (which meant lower
profits).
Discrimination by Customers and Governments
1.
Customer preferences may limit the ability of the profit motive to eliminate
discriminatory wage differentials.
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a.
If customers do not care whether they are being waited on by a blonde
or a brunette, the profit motive will work and both groups will eventually
be earning the same wage.
b.
If customers prefer brunettes, the entry of firms that hire blondes will
not succeed in eliminating the wage differential between blondes and
brunettes.
2.
Also, if the government mandates discriminatory practices, then the wage
differentials between the groups will continue to exist.
3.
Case Study: Discrimination in Sports
a.
Studies of sports teams suggest that racial discrimination is common and
that much of the blame lies with the customers.
b.
One study found that black basketball players earned 20% less than
white players of comparable ability did. Attendance at basketball games
was also higher for teams with a larger proportion of white players. So
even if the team owners cared only about profit, the customer
discrimination makes hiring black players less profitable than white
players.
c.
The same situation was found in baseball in the 1960s, but more recent
studies suggest that the wage differential in baseball no longer exists.
d.
Even the value of baseball cards has been affected by discrimination. A
1990 study found that the cards of black hitters sold for 10% less than
the cards of comparable white hitters. The cards of black pitchers sold
for 13% less than the cards of comparable white pitchers.
378 ) Chapter 19/Earnings and Discrimination
Activity 1—Even Money
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class assignment
Incentives, distribution of income
None
20 minutes
Works in any size class
Purpose
This assignment explores labor market issues by looking at an artificial situation of complete
equality. Notions of incentives and job differences are explored. This usually provokes lively
discussion, particularly if the proposal is presented as a realistic alternative.
Instructions
Have the class answer the following questions. Give them time to write an answer to a
question, then discuss their answers before moving to the next question.
Ask the students to consider replacing the current U.S. economic system with a system where
everyone is paid exactly the same salary. Assume that each family would receive an equal
share of GDP. For a typical four-person household, this would be over $90,000.
PMG
1. Would you personally favor this system? Explain.
2. What problems would exist?
3. What mechanisms could be enacted to overcome these problems?
4. Who would benefit from this system?
5. What jobs would be hard to fill?
Common Answers and Points for Discussion
1. Would you personally favor this system? Explain.
Most students oppose a completely egalitarian distribution of income. Some expect to
earn more under the existing system. Others see a variety of problems that make
equality unworkable. Others simply see it as “un-American.”
2. What problems would exist?
Numerous problems exist. National income may fall if the incentives to work are
changed drastically. People may not work at all. Others may put forth less work effort.
Unpleasant jobs are unlikely to be completed. Everyone would want a fun job. New
inventions and technological advance could be hindered. Saving and investment and
investment rates would be low. Education would become unimportant. Immigration
rates could increase.
3. What mechanisms could be enacted to overcome these problems?
Income could still be denied to people who did not work, and workers could still be fired
for inadequate effort. Households could be required to participate in the labor force.
Unpleasant jobs could be modified to improve safety, sanitation, or difficulty. Shorter
hours could be assigned to those performing the least desirable work. In short, a
complete set of alternative incentives would have to be developed. These incentives
become increasingly complex as more and more aspects of the price system are
replaced.
Chapter 19/Earnings and Discrimination ) 379
4. Who would benefit from equalizing the distribution of income?
A vast majority of households would gain (in the short run, if the system worked)
because the median household income is so much lower than an equal share of GDP.
5. What jobs would be hard to fill?
Students break into two groups on this question. Many see the undesirable jobs as
menial, rote, unsafe, or unclean. Slaughterhouses, garbage disposal, and assembly-line
work are frequent examples.
A relevant follow-up question is: “Why would these jobs be hard to fill at $90,000 a
year, when people currently work these jobs for much lower wages?”
Another group of students think professional jobs would be undesirable. Doctors,
lawyers, and executives are their examples.
Ask them, “Are these jobs worse than sucking the guts out of a dead chicken? These
jobs seem to have better working conditions, high levels of personal autonomy, and
some interesting challenges. Are people in these jobs motivated by more than money?”
Looking at the best jobs, many students seem to feel the ultimate “fun job” would be in
professional sports. Ask them why these workers need to receive millions of dollars in
compensation.
PMG
This assignment can be used to introduce a number of topics such as market allocation
of resources, distribution of income, risk premiums, compensating differentials, and
returns to human capital.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
A compensating differential is a difference in wages that arises to offset the nonmonetary
characteristics of different jobs. Examples include coal miners who earn extra wages to
compensate them for dangerous working conditions, workers on the night shift who get paid
more than day-shift workers, and professors who are paid less than lawyers and doctors.
More educated workers earn more than less educated workers because they are more
productive, so employers are willing to pay them more, and because more education may signal
greater innate ability.
2.
It is hard to establish whether a group of workers is being discriminated against because there
are many reasons other than discrimination for wages to differ across workers, such as
differences in human capital and job characteristics.
380 ) Chapter 19/Earnings and Discrimination
Profit-maximizing firms tend to eliminate discriminatory wage differentials because if some set of
workers were being discriminated against, it would be in the interest of profit-maximizing firms to
hire those workers with lower wages. But that, in turn, would raise the wages of those workers
until the wages of all similar workers were equal.
A discriminatory wage differential might persist if customers are willing to pay to maintain the
discriminatory practice or if the government mandates it.
Questions for Review
1.
Coal miners are paid more than other workers with similar amounts of education because their
higher wage compensates them for the dirty and dangerous nature of coal mining, as well as
their long-term health problems. As a result, they earn a sizable compensating differential.
2.
Education is a type of capital because it represents an expenditure of resources at one point in
time to raise productivity in the future.
3.
Education might raise a worker's wage without raising the worker's productivity if education
works as a signal that the worker has high ability.
4.
PMG
5.
The conditions that lead to economic superstars are: (1) every customer wants to enjoy the good
supplied by the best producer; and (2) the good is produced with a technology that makes it
possible for the best producer to supply every customer at a low cost. Because one dentist could
not supply every customer, you would not expect to see superstars in dentistry. But because
copies of music can be made at low cost, you would expect to see superstars in music.
A worker’s wage might be above the level that balances supply and demand because: (1)
minimum-wage laws raise wages above the levels that some workers would earn in an
unregulated labor market; (2) unions may have market power to raise wages above their
equilibrium level; and (3) a firm may find it profitable to pay an efficiency wage, which exceeds
the equilibrium wage, because doing so raises productivity.
6.
Deciding whether a group of workers has a lower wage because of discrimination is difficult
because people differ in other attributes, such as the amount of education they have, the amount
of experience they have, and the possibility of compensating differentials.
7.
The forces of economic competition tend to ameliorate discrimination on the basis of race,
because business owners who care only about making profit are at an advantage when
competing against those who also care about discriminating.
8.
Discrimination can persist in a competitive market if customers have a preference for
discrimination. For example, if customers prefer blonde waiters to brunettes, restaurants will
prefer to hire blonde waiters and they will discriminate against brunettes.
Problems and Applications
1.
a.
The opportunity cost of taking a job as a summer intern that pays little or nothing is the
wage that the student could earn at an alternative job.
b.
Despite the low wages, students are willing to take internships because an internship
might help them land a permanent job with the firm or the government later. Also, the
Chapter 19/Earnings and Discrimination ) 381
internship enhances the student's resume. Finally, the student may gain valuable on-thejob training.
c.
You would expect that students who were interns earn higher incomes later in life.
2.
The single minimum wage might distort the labor market for teenage workers more than for
adult workers because: (1) teenagers have a lower value of marginal product, so it is more likely
that the minimum wage will be above their value of marginal product; and (2) the demand for
teenage labor is more elastic than for adult labor, so the minimum-wage law distorts the market
more. The minimum wage affects those individuals who are least skilled and least experienced
and these characteristics certainly apply to teenagers.
3.
People with more experience usually have had more on-the-job training than others with the
same formal education but less experience. Such training increases the value of the marginal
product of their labor. Job tenure is also valuable, because people gain job-specific knowledge or
a specialization in knowledge that is useful to the firm.
4.
a.
PMG
b.
5.
6.
7.
Economics professors may receive higher salaries than professors in some other fields
because they have better opportunities outside academia. For example, they could find
jobs in the private sector or the government.
Differences in teaching loads can make up for lower pay. If professors in all fields are
paid the same, the pay level is probably below what economics professors could earn
elsewhere. To attract economics professors, the university would have to offer them
some other compensation, such as a lower teaching load.
Under the signaling theory, you would rather have the degree and not attend the university. But
under the human-capital theory, you would rather attend, even though doing so would be a
secret.
The development of recording devices led to a superstar phenomenon in which the best
musicians were paid significantly more than average musicians were paid. So the incomes of the
best musicians rose and the income of the average musician fell.
Yes, his behavior is profit maximizing. He is hiring labor at a lower cost. You might claim that
Alan is despicable because he is discriminating against men. Some might claim that Alan was
admirable, though, because he is maximizing profit and giving women a better opportunity to
find a job. If more employers were like Alan, the wage differential between men and women
would shrink, as employers would be competing for women workers, so women would have as
many job options as men. Ultimately, the wage differential could disappear. Other firms at the
time may not have followed his strategy because their customers may have preferred male
consultants.
382 ) Chapter 19/Earnings and Discrimination
Figure 1
8.
a.
PMG
b.
9.
10.
Figure 1 shows a situation in which young women are channeled into careers as
secretaries, nurses, and teachers. The left panel shows the labor market for secretaries,
nurses, and teachers, and the right panel shows the labor market for other fields. The
large supply of people in the secretarial, nursing, and teaching fields depresses the wage
in those fields. On the other hand, the smaller supply of labor in other fields raises the
relative wage.
Over time, if both men and women pursue more varied fields of work, the wages across
fields should equalize. The supply of labor in the market for secretaries, nurses, and
teachers will fall and the supply of labor in other fields will rise. Thus, the average wages
of men should decline relative to the average wages of women.
By the "pattern" of market work, O'Neill means that many women drop out of the labor force for
several years to start families and to care for their children when they are young. This means
they have less experience and job tenure, on average, than men of the same age and education.
Consequently, they are paid less.
If brunette workers do not like working with blonde workers, a blonde worker's marginal product
of labor is likely to be lower, because the firm's output will not be as high compared to the case if
the firm had a brunette worker instead. Thus, firms might find that blonde workers are not worth
as much and may reduce their wages relative to brunette workers. A profit-maximizing
entrepreneur could create a firm using all blonde workers, so there would be no frictions between
brunette and blonde workers. If there were many such entrepreneurs, the wage differential
between brunette and blonde workers would disappear over time.
20
INCOME INEQUALITY AND
POVERTY
WHAT’S NEW IN THE FOURTH EDITION:
There are two new In the News boxes on “The Global Distribution of Income” and “Child Labor.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
¾
the degree of economic inequality in our society.
¾
some problems that arise when measuring economic inequality.
¾
how political philosophers view the government’s role in redistributing income.
¾
the various policies aimed at helping poor families escape poverty.
PMG
CONTEXT AND PURPOSE:
Chapter 20 is the third chapter in a three-chapter sequence that addresses the economics of labor
markets. Chapter 18 developed the markets for the factors of production. Chapter 19 extended the basic
supply-and-demand model to help explain the wide variation in wages we find in the economy. Chapter
20 addresses the measurement of the distribution of income and looks at the role the government plays
in altering the distribution of income.
The purpose of Chapter 20 is to address income distribution. The discussion proceeds by
answering three questions. First, how much inequality is there? Second, what do different political
philosophies have to say about the proper role of government in altering the distribution of income? And
third, what are the various government policies that are used to help the poor?
KEY POINTS:
1. Data on the distribution of income show wide disparity in our society. The richest fifth of families
earns about ten times as much income as the poorest fifth.
383
384 ) Chapter 20/Income Distribution and Poverty
2. Because in-kind transfers, the economic life cycle, transitory income, and economic mobility are so
important for understanding variation in income, it is difficult to gauge the degree of inequality in our
society using data on the distribution of income in a single year. When these factors are taken into
account, they tend to suggest that economic well-being is more equally distributed than is annual
income.
3. Political philosophers differ in their views about the role of government in altering the distribution of
income. Utilitarians (such as John Stuart Mill) would choose the distribution of income to maximize
the sum of utility of everyone in society. Liberals (such as John Rawls) would determine the
distribution of income as if we were behind a “veil of ignorance” that prevented us from knowing our
own stations in life. Libertarians (such as Robert Nozick) would have the government enforce
individual rights to ensure a fair process but then not be concerned about inequality in the resulting
distribution of income.
4. Various policies aim to help the poor—minimum-wage laws, welfare, negative income taxes, and inkind transfers. Although each of these policies helps some families escape poverty, they also have
unintended side effects. Because financial assistance declines as income rises, the poor often face
effective marginal tax rates that are very high. Such high effective tax rates discourage poor families
from escaping poverty on their own.
PMG
CHAPTER OUTLINE:
I.
The Measurement of Inequality
A.
B.
To understand the distribution of income, we want to address four questions.
1.
How much inequality is there in our society?
2.
How many people live in poverty?
3.
What problems arise in measuring the amount of inequality?
4.
How often do people move among income classes?
U.S. Income Inequality
Encourage students to bring their textbooks to class on the day that you cover this
chapter so they can see these tables and charts up close while you are discussing
them. An alternative would be to provide handouts or use overheads or
PowerPoint® slides of the tables and charts. You may also want to check current
events for any new legislation that modifies the rules under which government
assistance programs operate.
1.
Table 1 shows the distribution of income in the United States by quintile.
2.
Table 2 shows the distribution of income in the U.S. over time.
Table 1
Table 2
Chapter 20/Income Distribution and Poverty ) 385
C.
a.
Throughout the past several decades, the bottom fifth of families has
received about 4 to 5 percent of income, while the top fifth has received
40 to 50 percent of income.
b.
From 1935 to 1970, the distribution gradually became more equal. Since
1970, this trend has reversed itself.
Income Inequality around the World
1.
Table 3 compares the income distribution in twelve countries.
2.
When countries are ranked by inequality, the United States ends up around the
middle of the pack. The U.S. has more income inequality than other
economically advanced countries (such as Japan, Germany, or Canada), but a
more equal distribution of income than many developing countries (such as
South Africa, Brazil, or Mexico).
Table 3
PMG
3.
D.
In the News: The Global Distribution of income
a.
This is an article from The New York Times that describes the rise in
economic growth that has been occurring recently in many lesser
developed countries around the world.
b.
The author of the article claims that this good news has been caused by
the increased level of globalization over the past decade. Many of these
countries have seen tremendous increases in international trade and
investment and this has led to a reduction in world poverty.
The Poverty Rate
1.
Definition of poverty rate: the percentage of the population whose family
income falls below an absolute level called the poverty line.
2.
Definition of poverty line: an absolute level of income set by the federal
government for each family size below which a family is deemed to be
in poverty.
3.
a.
In 2003, the poverty line for a family of four was $18,810.
b.
In 2003, the poverty rate was 12.5 percent.
Figure 1 shows the poverty rate in the United States since 1959.
Figure 1
a.
The poverty rate fell from 22.4 percent in 1959 to a low of 11.1 percent
in 1973.
386 ) Chapter 20/Income Distribution and Poverty
b.
4.
Since 1973, the increase in income inequality in the United States has
prevented the poverty rate from declining further.
Table 4 lists the poverty rates from 2003 for different groups of people.
Table 4
E.
a.
Poverty is correlated with race. Blacks and Hispanics are more likely to
live in poverty than are whites.
b.
Poverty is correlated with age. Children are more likely to live in poverty
and the elderly are less likely to live in poverty.
c.
Poverty is correlated with family composition. Families headed by a
female adult without a spouse present are more likely to live in poverty
than a family headed by a married couple.
Problems in Measuring Inequality
1.
In-Kind Transfers
PMG
2.
3.
a.
Definition of in-kind transfers: transfers to the poor given in the
form of goods and services rather than cash.
b.
Because standard measurements of income inequality are based on a
family's money income, they do not take into account these in-kind
transfers.
c.
A study by the Census Bureau showed that, if in-kind transfers were
included in money income at their market value, the number of families
living in poverty would decline by about 10 percent.
The Economic Life Cycle
a.
Definition of life cycle: the regular pattern of income variation
over a person's life.
b.
Young workers typically have low incomes. Income rises as the worker
matures and gains experience, peaks around age 50, and then declines
until the worker retires at age 65.
c.
People borrow and save to smooth out life-cycle changes in income.
Borrowing often occurs when the individual is young, and most
individuals save during middle-age.
Transitory versus Permanent Income
a.
Definition of permanent income: a person's normal income.
b.
To gauge inequality of living standards, the distribution of permanent
income is more relevant than the distribution of annual income.
Chapter 20/Income Distribution and Poverty ) 387
c.
F.
II.
Because permanent income excludes transitory changes in income,
permanent income is more equally distributed than is current income.
Economic Mobility
1.
Economic mobility is the movement of people among income classes and occurs
often in the U.S. economy.
2.
Because economic mobility is great, many of those below the poverty line are
there only temporarily.
3.
Economists have found substantial mobility in terms of economic success from
generation to generation.
4.
The U.S. economy is filled with self-made millionaires. Approximately 80 percent
of the millionaires in the United States made their money on their own as
opposed to inheriting it.
The Political Philosophy of Redistributing Income
A.
Utilitarianism
PMG
1.
Definition of utilitarianism: the political philosophy according to which
the government should choose policies to maximize the total utility of
everyone in society.
2.
Definition of utility: a measure of happiness or satisfaction.
3.
The founders of utilitarianism are Jeremy Bentham and John Stuart Mill.
4.
The utilitarian case for redistributing income is based on the assumption of
diminishing marginal utility.
5.
a.
An extra dollar of income to a poor person provides that person with
more additional utility than does an extra dollar to a rich person.
b.
As a person's income rises, the extra satisfaction from an additional
dollar of income declines.
However, utilitarians do not believe that all incomes should be equal.
a.
Principle #3: People respond to incentives.
b.
If all incomes were to be equalized, this would reduce the incentive to
work hard. If individuals do not work as hard, total income falls, which
lowers total utility.
c.
Thus, in a utilitarian's opinion, the government must balance the gains
from greater equality against the losses caused by the distorted
incentives.
388 ) Chapter 20/Income Distribution and Poverty
B.
Liberalism
1.
Definition of liberalism: the political philosophy according to which the
government should choose policies deemed to be just, as evaluated by
an impartial observer behind a “veil of ignorance.”
2.
This is a political philosophy developed by John Rawls.
3.
Rawls considered what income distribution a person would consider just if that
person did not know whether he or she would end up at the top, bottom, or in
between.
a.
Rawls believed that a person would be most concerned about being at
the bottom of the income distribution.
b.
Thus, public policy should aim to raise the welfare of the worst-off
person in society.
c.
Definition of the maximin criterion: the claim that the government
should aim to maximize the well-being of the worst-off person
in society.
PMG
C.
d.
This idea suggests that we should consider income redistribution as a
form of social insurance.
e.
Definition of social insurance: government policy aimed at
protecting people against the risk of adverse events.
f.
It is not clear that rational people would be so truly risk averse as to
follow the maximin criterion. If a person were to treat all outcomes as
equally likely, the best policy would be to maximize the average utility of
the members of society (as suggested by utilitarianism).
Libertarianism
1.
Definition of libertarianism: the political philosophy according to which
the government should punish crimes and enforce voluntary
agreements but not redistribute income.
2.
Libertarians believe that society itself earns no income; only individual members
of society earn income.
3.
Libertarians also believe that the government should not take income from some
individuals and give it to others to achieve any particular distribution of income.
4.
Libertarians conclude that equality of opportunities is more important than
equality of incomes. Thus, they believe that the government should enforce
individual rights to ensure that everyone has an equal opportunity to make the
most of his or her talents and achieve success.
Present several imaginary quotes from utilitarians, liberals, and libertarians regarding
the 1996 Welfare Reform Act. Ask students to determine which philosophy the
speaker follows regarding income distribution.
Chapter 20/Income Distribution and Poverty ) 389
III.
Policies to Reduce Poverty
A.
Minimum-Wage Laws
1.
2.
For workers with low levels of skill and experience, a high minimum wage forces
the wage above equilibrium.
a.
This leads to higher unemployment among those groups of workers
affected by the minimum wage.
b.
Although those workers who remain employed benefit from a higher
wage, those who might have been employed at a lower wage are worse
off.
The magnitude of the effect depends on the elasticity of demand for labor.
a.
If the demand for labor is elastic, firms will lower employment more than
if the demand is inelastic.
b.
This is especially true in the long run, when firms can adjust to the
higher wage more fully.
PMG
3.
B.
Critics of the minimum wage also point out that many teenagers earning the
minimum wage are from middle-class families, so that a high minimum wage
does a bad job of targeting the poor.
Welfare
1.
Definition of welfare: government programs that supplement the
incomes of the needy.
2.
Temporary Assistance for Needy Families (TANF) and Supplemental Security
Income (SSI) are two welfare programs.
3.
A common criticism of these programs is that they create incentives for people to
become needy.
a.
These programs may encourage families to break up, because many
families qualify only if the father is absent.
b.
These programs may also encourage illegitimate births, because many
poor, single women qualify only if they have children.
4.
Proponents argue that being a poor, single mother on welfare is not a life that
someone would choose. Trends also indicate that, while the amount of welfare
benefits (adjusted for inflation) has fallen since the 1970s, the percentage of
children living with a single parent has risen.
5.
The Earned Income Tax Credit works like a negative income tax for the working
poor.
390 ) Chapter 20/Income Distribution and Poverty
C.
D.
In-Kind Transfers
1.
The federal government provides the poor with food stamps and Medicaid.
2.
Advocates of in-kind transfers argue that these make sure that the poor receive
what they need most.
3.
Advocates of cash payments argue that the government cannot know what
goods and services the poor need the most.
Anti-Poverty Programs and Work Incentives
1.
2.
Many policies for the poor have the unintended effect of discouraging work.
a.
A person discouraged from working loses the on-the-job training that a
job might offer.
b.
Children will not get to see their parents with a full-time job and this
may impair their own ability to find and hold a job when they get older.
Welfare, Medicaid, food stamps, and the Earned Income Tax Credit all have
eligibility requirements that are tied to income level.
PMG
E.
a.
As a family's income rises, it becomes ineligible for these programs.
b.
When all programs are taken into account, these families face marginal
tax rates that are very high.
3.
One possible solution would be to gradually phase out the benefits gradually as
the family's income level rises. However, this would raise the costs of these
programs substantially.
4.
In 1996, the government passed a welfare-reform law that limits the amount of
time that any person can collect welfare.
a.
After the passage of this law, welfare rolls decreased.
b.
In addition, there was a large increase in the employment levels among
those groups traditionally on welfare.
In the News: Child Labor
1.
Research indicates that child labor around the world is a result of poverty.
2.
This is an article from The New York Times that discusses recent economic
research concerning the effects of family income on child labor around the globe.
Chapter 20/Income Distribution and Poverty ) 391
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
The poverty rate measures the percentage of the population whose family income falls below an
absolute level called the poverty line. It tells you something about the distribution of income at
the lower end of the income scale.
Three potential problems in interpreting the measured poverty rate are: (1) in-kind transfers are
not accounted for in the poverty rate, so the poverty rate overstates the amount of poverty; (2)
the poverty rate is based on annual income, but income over the life cycle is much more equally
distributed than annual income; and (3) the poverty rate is affected by temporary changes in
income, but inequality would be better measured by looking at permanent income.
2.
3.
Based on the assumption of diminishing marginal utility of income, a utilitarian would favor some
redistribution of income from Pam to Pauline because it would increase the total utility of society.
A liberal would want to maximize the utility of the least well-off person in society, so a liberal
would favor even greater redistribution. A libertarian would not want to redistribute income from
Pam to Pauline as long as the process of earning income was a fair one.
PMG
Policies aimed at helping the poor include minimum-wage laws, welfare, a negative income tax,
and in-kind transfers. Minimum-wage laws can help the working poor without any cost to the
government but have the disadvantage of causing unemployment among some workers. Welfare
assists the poor with direct aid but creates incentives for people to become needy. The negative
income tax is a good way to implement a program of financial aid for the poor and does not
distort incentives as much as some other programs do, but it may support those who are lazy
and unwilling to work. In-kind transfers provide goods and services directly to the poor, ensuring
that the poor get necessities such as food and shelter, but the government may not know what
the poor need the most.
Questions for Review
1.
The richest fifth of the U.S. population earns about ten times as much income as the poorest
fifth.
2.
In comparison with other nations around the world, the United States is about average in terms
of income equality. The United States has a more unequal distribution of income than countries
like Germany and Canada, but a more equal distribution than many developing countries, such as
Mexico and Brazil.
3.
In the U.S. population, the groups most likely to live in poverty are blacks and Hispanics,
children, and families headed by a female adult without a spouse present.
4.
Since people may have temporarily high or low income and since income varies over the life cycle
(people's incomes are lower when young and higher when older), annual income does not
represent true inequality in living standards.
5.
A utilitarian would like everyone to have equal incomes, but would recognize that redistributing
income distorts incentives, so would proceed only part way to that goal. A liberal would go
392 ) Chapter 20/Income Distribution and Poverty
further than a utilitarian in equalizing incomes, since a liberal would focus on the well being of
the worst-off person in society. A libertarian would not care about equalizing incomes at all as
long as the process of getting income is fair.
6.
In-kind transfers are beneficial because they ensure that the poor get what they need most. In
particular, they get food and shelter instead of alcohol and drugs. But in-kind transfers are not
as beneficial to the recipients as cash because they provide no opportunity for substitution into
more highly valued goods. The poor are in the best position to know what they need.
7.
Antipoverty programs can discourage the poor from working because they effectively tax away
earnings by significantly reducing benefits when a person earns income. This disincentive could
be reduced by reducing the benefits more gradually, but the program would be much more
expensive.
Problems and Applications
1.
2.
3.
4.
5.
The factors contributing to the increase in income inequality in the United States during the past
30 years are the breakup of families, making poor families even poorer, and the increase in the
number of two-career families, making rich families even richer.
PMG
The percentage of children in families with income below the poverty line is almost twice the
percentage of the elderly in such families because the Social Security system supports the elderly
quite well, but the TANF (Temporary Assistance for Needy Families) program has incentive
effects that tend to keep families from working their way out of poverty.
Students' current incomes are substantially less than their permanent incomes, so current
incomes don't reflect their standards of living very well. They may borrow now or be supported
by their parents, but their college education will pay off with higher future incomes.
a.
To increase economic mobility within a generation, the government could support
training programs (to provide skills to unskilled workers) and workfare instead of welfare
(to help the poor increase their incomes).
b.
To increase economic mobility across generations, the government might increase its
support for education.
c.
The advantage of reducing spending on welfare to increase spending on programs that
enhance economic mobility is that it gives people greater incentive to work hard to get
ahead. The disadvantages are that such programs are expensive and are hard on those
who do not make it.
Community 1 has ten families with income of $100,000 each and ten families with income of
$20,000 each. Community 2 has ten families with income of $200,000 each and ten families with
income of $22,000 each.
a.
Community 2 has more unequal income than community 1. In community 2 the rich
have nearly ten times the income of the poor, while in community 1 the rich have only
five times the income of the poor. However, the problem of poverty is likely to be
slightly worse in community 1, since the poor have lower income.
Chapter 20/Income Distribution and Poverty ) 393
6.
7.
8.
9.
b.
Rawls would prefer the distribution of income in community 2, since the worst-off family
has more income than in community 1.
c.
Most people will prefer the income distribution of community 2, since both rich and poor
families are better off than their counterparts in community 1, even though inequality is
greater.
d.
A utilitarian may prefer the income distribution of community 1 because income is more
equal across its citizens.
a.
Leaks in the bucket are caused by the administrative costs of redistributing income,
people who lie about their income to cheat the system, and the fact that labor supply is
elastic, so that redistributive taxes reduce labor supply.
b.
Generally, Republicans believe the redistributive bucket is more leaky than do Democrats.
As a result, they think the government should do less redistribution of income than do
Democrats.
a.
A utilitarian would argue that the marginal utility of income for the person with an
income of $10,000 is higher than the marginal utility of income for someone with an
income of $30,000, so income should be redistributed.
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b.
Rawls would prefer the second distribution since the worst-off person is better off than in
the first distribution.
c.
Nozick would not find either more equitable. He would think the most equitable
distribution is the one in which people got what they deserved. If the rules of the game
are fair, either distribution is quite acceptable.
a.
If people received cash instead of Medicaid benefits, it is unlikely that they would spend
as much on health care. Instead, they would purchase other things they want or need.
b.
This suggests that we probably should not value in-kind transfers at the price the
government pays for them. They may not be worth as much as their cost.
c.
Since the poor would prefer other things to Medicaid, it might be better to give them
cash transfers instead.
a.
Since the woman receives a smaller TANF benefit when she earns a dollar more, she will
be less likely to work. Thus, the labor supply of low-income women will be lower as a
result of the TANF program.
b.
If an individual would receive a greater benefit when he earns more income, he will be
more likely to work. Thus, the EITC has a positive effect on the labor supply of lowincome workers.
c.
TANF provides a safety net for those who are less likely to be successful in the labor
market.
394 ) Chapter 20/Income Distribution and Poverty
10.
a.
The following table shows pre-tax income, taxes paid to the government (a negative
amount means money is received from the government), and after-tax income:
Pre-Tax Income
$0
10,000
20,000
30,000
40,000
11.
Taxes
$ –10,000
–5,000
0
5,000
10,000
After-Tax Income
$10,000
15,000
20,000
25,000
30,000
b.
The marginal tax rate is 50 percent, since an increase in pre-tax income of $10,000 leads
to higher taxes of $5,000. The maximum income at which a family receives money from
the government is $19,999.99.
c.
The change in the tax schedule gives a marginal tax rate of 25 percent. The maximum
income at which a family receives money from the government is now $39,999.99.
d.
The advantage of the first tax schedule is that the after-tax income distribution would be
more equal. The advantage of the second tax schedule is that the marginal tax rate
would be lower, so it would not cause as much of a distortion to labor supply.
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Since John believes that labor supply is highly elastic, he will want less redistribution of income,
because elastic labor supply means a greater distortion from redistributive policies.
21
THE THEORY OF CONSUMER
CHOICE
WHAT’S NEW IN THE FOURTH EDITION:
There are no substantial changes to this chapter.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
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¾
how a budget constraint represents the choices a consumer can afford.
¾
how indifference curves can be used to represent a consumer’s preferences.
¾
how a consumer’s optimal choices are determined.
¾
how a consumer responds to changes in income and changes in prices.
¾
how to decompose the impact of a price change into an income effect and a substitution effect.
¾
how to apply the theory of consumer choice to three questions about household behavior.
CONTEXT AND PURPOSE:
Chapter 21 is the first of two unrelated chapters that introduce students to advanced topics in
microeconomics. These two chapters are intended to whet their appetites for further study in economics.
Chapter 21 is devoted to an advanced topic known as the theory of consumer choice.
The purpose of Chapter 21 is to develop the theory that describes how consumers make
decisions about what to buy. So far, these decisions have been summarized with the demand curve. The
theory of consumer choice underlies the demand curve. After developing the theory, the theory is applied
to a number of questions about how the economy works.
395
396 ) Chapter 21/The Theory of Consumer Choice
KEY POINTS:
1. A consumer’s budget constraint shows the possible combinations of different goods he can buy given
his income and the prices of the goods. The slope of the budget constraint equals the relative price
of the goods.
2. The consumer’s indifference curves represent his preferences. An indifference curve shows the
various bundles of goods that make the consumer equally happy. Points on higher indifference curves
are preferred to points on lower indifference curves. The slope of an indifference curve at any point is
the marginal rate of substitution—the rate at which the consumer is willing to trade one good for the
other.
3. The consumer optimizes by choosing the point on his budget constraint that lies on the highest
indifference curve. At this point, the slope of the indifference curve (the marginal rate of substitution
between the goods) equals the slope of the budget constraint (the relative price of the goods).
4. When the price of a good falls, the impact on the consumer’s choices can be broken down into an
income effect and a substitution effect. The income effect is the change in consumption that arises
because a lower price makes the consumer better off. The substitution effect is the change in
consumption that arises because a price change encourages greater consumption of the good that
has become relatively cheaper. The income effect is reflected in the movement from a lower to a
higher indifference curve, whereas the substitution effect is reflected by a movement along an
indifference curve to a point with a different slope.
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5. The theory of consumer choice can be applied in many situations. It can explain why demand curves
can potentially slope upward, why higher wages could either increase or decrease the quantity of
labor supplied, and why higher interest rates could either increase or decrease saving.
CHAPTER OUTLINE:
This chapter is an advanced treatment of consumer choice using indifference curve
analysis. This chapter is much more difficult than the other chapters in the text. Most
undergraduate principles students will find this material challenging.
I.
The Budget Constraint: What the Consumer Can Afford
The best way to develop this model is to use specific examples with definite
quantities, prices, and levels of income.
A.
Example: A consumer has an income of $1,000 per month to spend on pizza and Pepsi.
The price of a pizza is $10 and the price of a pint of Pepsi is $2.
Chapter 21/The Theory of Consumer Choice ) 397
B.
If the consumer spends all of his income on pizza, he can buy 100 pizzas per month. If
the consumer spends all of his income on pints of Pepsi, he can buy 500 pints per month.
C.
Definition of budget constraint: the limit on the consumption bundles that a
consumer can afford.
D.
Using this information, we can draw the consumer's budget constraint.
a.
The slope of the budget constraint measures the rate at which the consumer can
trade one good for another.
b.
The slope of the budget constraint equals the relative price of the two goods (1
pizza can be traded for 5 pints of Pepsi).
Figure 1
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Although the book does it later, now might be a good time to show the effects of
price and income changes. Show mathematically and graphically how a doubling (or
halving) of the price of one good will cause its intercept to change. Also show what
happens to the vertical and horizontal intercepts when income changes. Emphasize
that the budget depicts the consumption possibilities available to the individual. The
consumer can be on or within the budget constraint, but not beyond it.
398 ) Chapter 21/The Theory of Consumer Choice
Activity 1—You Can’t Always Get What You Want
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class activity
Budget constraints
None
5 minutes
Works in any size class
Purpose
This activity shows consumers are restricted by their limited incomes and by the prices of
goods.
Instructions
Ask the students to think about maximizing their own utility.
Specifically, ask them to assume that billionaire Bill Gates offers to buy them the one thing
that would increase their happiness by the greatest amount. It cannot be money or a financial
instrument, but he will buy them any single thing they feel would make them happy. Have
them write down their requested item.
Ask a few students what they chose. Then ask the class, “Why don’t you buy that item for
yourself? Isn’t it the one thing that will increase your happiness by the largest amount? Why
not buy it today?”
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The answer, of course, is they cannot afford it. Consumers’ purchases are constrained by
their incomes.
However, that is not the only constraint. Ask them to estimate the cost of their selected items
and write it next to the items. Now, have them assume Bill Gates is too busy to go shopping,
so he gives them the money instead. He does not put any restrictions on the use of the cash;
all he wants is to see them maximize their happiness.
This eliminates the income barrier. Ask the class how many of them would spend the entire
amount of money buying that single good.
Some students would buy that item, but most would buy a variety of things. Using the money
for a single expensive item may not be the best way to allocate their newfound wealth.
Buying several cheap things may give a higher level of happiness.
Points for Discussion
1) Consumers have limited income.
2) Goods have prices.
Together these things determine the consumer’s budget constraint.
II.
Preferences: What the Consumer Wants
A.
Figure 2
Representing Preferences with Indifference Curves
Chapter 21/The Theory of Consumer Choice ) 399
1.
A consumer is indifferent between two bundles of goods and services if the two
bundles suit his tastes equally well.
2.
Definition of indifference curve: a curve that shows consumption bundles
that give the consumer the same level of satisfaction.
3.
The consumer is indifferent among points A, B, and C.
4.
Definition of marginal rate of substitution: the rate at which a consumer
is willing to trade one good for another.
5.
The marginal rate of substitution is equal to the slope of the indifference curve at
any point.
a.
Because these indifference curves are not straight lines, the marginal
rate of substitution is not the same at all points on a given indifference
curve.
b.
The rate at which a consumer is willing to trade one good for the other
depends on how much of each good he is already consuming.
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6.
A consumer’s set of indifference curves gives a complete ranking of the
consumer’s preferences.
7.
Any point on indifference curve I2 will be preferred to any point on indifference
curve I1.
a.
It is obvious that point D would be preferred to point A because point D
contains more pizza and more Pepsi.
400 ) Chapter 21/The Theory of Consumer Choice
b.
B.
We can tell, though, that point D is also preferred to point C because
point D is on a higher indifference curve.
Four Properties of Indifference Curves
1.
Higher indifference curves are preferred to lower ones.
2.
Indifference curves are downward sloping.
3.
a.
In most cases, the consumer would like more of both goods.
b.
If the quantity of one good increases, the quantity of the other good
must fall in order for the consumer to remain equally satisfied.
Indifference curves do not cross.
Figure 3
a.
The easiest way to prove this is by showing what would happen if they
did cross.
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4.
Figure 4
b.
Because point A is on the same indifference curve as point B, the two
bundles make the consumer equally happy.
c.
Because point C is on the same indifference curve as point B, the two
bundles make the consumer equally happy.
d.
But this should imply that points A and C make the consumer equally
happy, even though point C represents a bundle with more of both
goods (which makes it preferred to point A).
Indifference curves are bowed inward.
Chapter 21/The Theory of Consumer Choice ) 401
C.
a.
The slope of the indifference curve is the rate at which the consumer is
willing to trade one good for another.
b.
Because people are more willing to trade away goods that they have in
abundance and less willing to trade away goods of which they have little,
the marginal rate of substitution falls as the consumer gains pizza and
loses Pepsi.
Two Extreme Examples of Indifference Curves
Figure 5
1.
Perfect Substitutes
a.
Examples: bundles of nickels and dimes.
b.
Most likely, a consumer would always be willing to trade one dime for
two nickels, regardless of how many dimes or nickels he or she has.
c.
Definition of perfect substitutes: two goods with straight-line
indifference curves.
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d.
2.
III.
Because the marginal rate of substitution is the same no matter how
many dimes and nickels the consumer has, the slope of the indifference
curve is constant. Thus, the indifference curve is a straight line.
Perfect Complements
a.
Example: right shoes and left shoes.
b.
Most likely, the consumer would only care about the number of pairs of
shoes.
c.
Thus, a bundle with five right shoes and five left shoes makes a
consumer equally as happy as a bundle with seven right shoes and five
left shoes.
d.
Definition of perfect complements: two goods with right-angle
indifference curves.
Optimization: What the Consumer Chooses
A.
The Consumer's Optimal Choices
Figure 6
1.
The consumer would like to end up on the highest possible indifference curve,
but he must also stay within his budget.
2.
The highest indifference curve the consumer can reach is the one that just barely
touches the budget constraint. The point where they touch is called the
optimum.
402 ) Chapter 21/The Theory of Consumer Choice
3.
The optimum point represents the best combination of Pepsi and pizza available
to the consumer.
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4.
B.
a.
The consumer would prefer point A, but he cannot afford that bundle
because it lies outside of his budget constraint.
b.
The consumer could afford bundle B, but it lies on a lower indifference
curve and therefore provides less satisfaction.
At the optimum, the slope of the budget constraint is equal to the slope of the
indifference curve.
a.
The indifference curve is tangent to the budget constraint at this point.
b.
At this point, the marginal rate of substitution is equal to the relative
price of the two goods.
c.
The relative price is the rate at which the market is willing to trade one
good for the other, while the marginal rate of substitution is the rate at
which the consumer is willing to trade one good for the other.
FYI: Utility: An Alternative Way to Describe Preferences and Optimization
1.
Utility is an abstract measure of the satisfaction that a consumer receives from a
bundle of goods and services.
2.
A consumer will prefer bundle A to bundle B if bundle A provides more utility.
3.
Indifference curves and utility are related.
a.
Bundles of goods in higher indifference curves provide a higher level of
utility.
Chapter 21/The Theory of Consumer Choice ) 403
4.
C.
b.
Bundles of goods on the same indifference curve all provide the same
level of utility.
c.
The slope of the indifference curve reflects the marginal utility of one
good compared to the marginal utility of the other good.
A consumer can maximize his utility if he ends up on the highest indifference
curve possible.
a.
This occurs when MRS = PX/PY.
b.
Because MRS = MUX/MUY, optimization occurs where MUX/MUY = PX/PY.
c.
This can be rewritten as MUX/PX = MUY/PY.
d.
This implies that, at the consumer’s optimum, the marginal utility per
dollar spent on good X equals the marginal utility per dollar spent on
good Y.
How Changes in Income Affect the Consumer's Choices
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Figure 7
1.
A change in income shifts the budget constraint.
a.
An increase in income can be shown by an outward shift of the budget
constraint; a decrease in income means that the budget constraint shifts
inward.
b.
Because the relative price of the two goods has not changed, the slope
of the budget constraint remains the same.
2.
An increase in income means that the consumer can now reach a higher
indifference curve.
3.
Because the consumer increased his consumption of both goods when his
income increased, both Pepsi and pizza must be normal goods.
a.
Definition of normal good: a good for which an increase in income
raises the quantity demanded.
b.
Definition of inferior good: a good for which an increase in
income reduces the quantity demanded.
Figure 8
D.
How Changes in Prices Affect the Consumer's Choices
Figure 9
1.
If the price of only one good changes, the budget constraint will tilt.
404 ) Chapter 21/The Theory of Consumer Choice
2.
Suppose that the price of Pepsi falls from $2 per pint to $1.
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3.
E.
Figure 10
Table 1
a.
If the consumer spends his entire income on pizza, the change in the
price of Pepsi will not affect his ability to buy pizza, so point A on the
budget constraint remains the same.
b.
If the consumer spends his entire income on Pepsi, he will now be able
to buy 1,000 pints instead of only 500. Thus, the end point of his budget
constraint moves from point B to point D.
c.
The slope of the budget constraint changes as well. Because the price of
Pepsi has fallen, the relative price of the two goods has changed. The
consumer can now trade a pizza for 10 pints of Pepsi instead of 5.
Therefore, the budget constraint has become steeper.
How such a change in the price of one good alters the consumption of both
goods depends on the consumer's preferences.
Income and Substitution Effects
1.
Definition of income effect: the change in consumption that results when
a price change moves the consumer to a higher or lower indifference
curve.
2.
Definition of substitution effect: the change in consumption that results
when a price change moves the consumer along a given indifference
curve to a point with a new marginal rate of substitution.
3.
Suppose that the price of Pepsi falls.
a.
The decrease in the price of Pepsi will make the consumer better off.
Thus, if pizza and Pepsi are both normal goods, the consumer will want
to spread this improvement in his purchasing power over both goods.
Chapter 21/The Theory of Consumer Choice ) 405
This is the income effect and will make the consumer want to buy more
of both goods.
b.
At the same time, the consumption of Pepsi has become less expensive
relative to the consumption of pizza. This is the substitution effect and it
will tend to make the consumer want to purchase more Pepsi and less
pizza.
c.
The end result must mean that the consumer purchases more Pepsi
because both effects move the consumer in that direction. But it is
ambiguous whether the consumer buys more pizza, because the income
and substitution effects move in opposite directions.
PMG
Students can learn to separate the substitution effects easily if they follow a simple
rule: Have them draw a line tangent to the original indifference curve but parallel to
the new budget constraint. Make sure that they realize that the substitution effect is
seen as the movement along one indifference curve (due to changes in relative
prices), and the income effect is seen as the movement from one budget constraint
to a parallel budget constraint (because the individual’s purchasing power has
changed).
4.
We can graphically decompose the change in the consumer's decision into the
income effect and the substitution effect.
a.
First, the consumer moves from the initial optimum (point A) to point B.
The consumer is equally happy at either of these points, but the
marginal rate of substitution at point B reflects the new relative prices of
the two goods.
b.
Second, the consumer shifts to higher indifference curve I2 by moving
from point B to C. At these two points, the marginal rate of substitution
is the same because the slope of indifference curve I1 at point B is equal
to the slope of indifference curve I2 at point C.
406 ) Chapter 21/The Theory of Consumer Choice
c.
F.
The movement from point A to point B is the substitution effect; the
movement from point B to point C is the income effect.
Deriving the Demand Curve
Figure 11
IV.
1.
A demand curve shows how the price of a good affects the quantity demanded.
2.
We can view a consumer's demand curve as a summary of the optimal decisions
that arise from his budget constraint and indifference curves.
3.
When the price of Pepsi falls from $2 per pint to $1, the consumer's budget
constraint shifts outward, leading to both an income effect and a substitution
effect. The consumer moves from point A to point B, increasing his consumption
of Pepsi from 50 pints to 150.
4.
Note that at a price of $2, the consumer's quantity of Pepsi demanded is 50. At a
price of $1, quantity demanded is 150. These are two of the points on his
demand curve for Pepsi.
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Three Applications
A.
Do All Demand Curves Slope Downward?
Figure 12
1.
The law of demand states that when the price of a good rises, people buy less of
it.
2.
However, it is possible that when the price of a good rises, people actually buy
more of it.
3.
Example: A consumer spends his entire budget on meat and potatoes. The price
of potatoes rises.
a.
The budget constraint will shift in.
b.
The substitution effects suggest that the consumer choose more meat
and fewer potatoes.
c.
The income effect suggests that the individual has suffered a decline in
purchasing power and therefore will choose to decrease his consumption
of normal goods and increase his consumption of inferior goods.
d.
Suppose that potatoes are an inferior good. When the price of potatoes
rises, the substitution effect says that the consumer should consume
fewer potatoes, while the income effect suggests that he will consume
more potatoes. If the income effect dominates, the consumer will end up
consuming more potatoes even though the price of potatoes rose.
Chapter 21/The Theory of Consumer Choice ) 407
B.
4.
Definition of Giffen good: a good for which an increase in the price raises
the quantity demanded.
5.
Giffen goods are very rare, so the law of demand can generally be relied upon.
How Do Wages Affect Labor Supply?
Figure 13
1.
Example: Sally has 100 hours per week that she can devote to working or
enjoying leisure. Her hourly wage is $50, which she spends on consumption
goods.
2.
We can show Sally's budget constraint graphically.
a.
On the horizontal axis, we have hours of leisure. On the vertical axis, we
have consumption goods.
b.
If Sally spends all of her time in leisure (100 hours), she will have no
consumption. If she spends all of her time working, she will have no
leisure but will have consumption of $5,000.
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Figure 14
3.
Sally's optimum will occur where the highest possible indifference curve is
tangent to the budget constraint.
4.
If Sally's wage increases, her budget constraint will shift outward.
a.
The budget constraint will become steeper, because Sally can get more
consumption for every hour of leisure that she gives up.
b.
We would expect that consumption would rise, because both of the
income and substitution effects move in that direction. When the wage
rises, leisure becomes relatively more expensive. Thus, Sally will increase
consumption and decrease leisure. Also when Sally's wage rises, her
purchasing power is increased. Because consumption is a normal good,
Sally will want more consumption.
c.
The response of leisure to the change in Sally's wage is not as
straightforward. This occurs because the income and substitution effects
with regard to leisure move in opposite directions. When the wage rises,
leisure becomes relatively more expensive. Therefore, Sally will want to
consume less leisure. However, when Sally's wage rises, her purchasing
power is increased, causing her to increase her desire for more leisure
(because it is a normal good). The end result depends on which effect is
dominant.
d.
If the substitution effect is greater than the income effect, Sally will
decrease leisure and work more hours if her wage rises. This results in
an upward-sloping labor supply curve.
408 ) Chapter 21/The Theory of Consumer Choice
e.
5.
C.
If the income effect is greater than the substitution effect, Sally will
increase leisure and work fewer hours if her wage rises. This results in a
backward-bending labor supply curve.
Case Study: Income Effects on Labor Supply: Historical Trends, Lottery Winners,
and the Carnegie Conjecture
a.
One hundred years ago, workers worked six days a week. As wages
(adjusted for inflation) have risen, the length of the workweek has fallen.
This suggests that a backward-bending labor supply curve is not
unrealistic.
b.
The income effect can be isolated by examining the effects of winning
the lottery on an individual's labor supply. Studies have shown that
lottery prizes lead to significant decreases in labor supply. This is why
Andrew Carnegie gave away much of his wealth before he died rather
than leaving it for his children. He worried that such wealth would lead
his children to become unproductive.
How Do Interest Rates Affect Household Saving?
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Figure 15
1.
Example: Sam is planning ahead for retirement. There are two time periods.
Currently, Sam is young and working and able to earn a total income of
$100,000. In the next period, Sam is old and retired. He will have to consume
using funds he saved while young. Assume that the interest rate is 10 percent.
2.
We can view "consumption while young" and "consumption while old" as the two
goods that Sam must choose between.
3.
The interest rate determines the relative price of these two goods. For every
dollar that Sam saves while he is young, he can consume $1.10 when he is old.
4.
We can draw Sam's budget constraint.
a.
On the horizontal axis, we have "consumption when young" and on the
vertical axis, we have "consumption while old."
b.
If Sam saves nothing, he will consume $100,000 when he is young and
zero when he is old. Likewise, if he consumes nothing when he is young,
he will be able to consume $110,000 when he is old.
5.
Sam's optimum occurs where his highest possible indifference curve is tangent to
his budget constraint.
6.
If the interest rate rises to 20 percent, two possible outcomes could occur.
Figure 16
a.
The increase in the interest rate raises the price of "consumption when
young." The substitution effect suggests that Sam would lower the
amount of consumption when young and save more for the future.
Chapter 21/The Theory of Consumer Choice ) 409
7.
b.
Because the increase in the interest rate means an increase in
purchasing power, the income effect suggests that Sam increase his
consumption of normal goods. Because "consumption when young" is a
normal good, Sam will want to save less.
c.
Thus, the end result will depend on whether the income effect or the
substitution effect dominates. If the substitution effect is larger than the
income effect, Sam will save more for the future and decrease
consumption when young. If the income effect is greater than the
substitution effect, Sam will save less for the future and increase
consumption when young.
Because of this ambiguity, it is not clear how changing the way interest income is
taxed will affect overall savings rates.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
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The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
A person with an income of $1,000 could purchase $1,000/$5 = 200 pints of Pepsi if she spent all
of her income on Pepsi or she could purchase $1,000/$10 = 100 pizzas if she spent all of her
income on pizza. Thus, the point representing 200 pints of Pepsi and no pizzas is the vertical
intercept and the point representing 100 pizzas and no Pepsi is the horizontal intercept of the
budget constraint, as shown in Figure 1. The slope of the budget constraint is the rise over the
run, or -200/100 = -2.
Figure 1
410 ) Chapter 21/The Theory of Consumer Choice
2.
Figure 2 shows indifference curves between Pepsi and pizza. The four properties of these
indifference curves are: (1) higher indifference curves are preferred to lower ones because
consumers prefer more of a good to less of it; (2) indifference curves are downward sloping
because if the quantity of one good is reduced, the quantity of the other good must increase in
order for the consumer to be equally happy; (3) indifference curves do not cross because if they
did, the assumption that more is preferred to less would be violated; and (4) indifference curves
are bowed inward because people are more willing to trade away goods that they have in
abundance and less willing to trade away goods of which they have little.
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Figure 2
Chapter 21/The Theory of Consumer Choice ) 411
3.
Figure 3 shows the budget constraint (BC1) and two indifference curves. The consumer is initially
at point A, where the budget constraint is tangent to an indifference curve. The increase in the
price of pizza shifts the budget constraint to BC2, and the consumer moves to point C where the
new budget constraint is tangent to a lower indifference curve. To break this move down into
income and substitution effects requires drawing the dashed budget line shown, which is parallel
to the new budget constraint and tangent to the original indifference curve at point B. The
movement from A to B represents the substitution effect, while the movement from B to C
represents the income effect.
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Figure 3
4.
An increase in the wage can potentially decrease the amount that a person wants to work
because a higher wage has an income effect that increases both leisure and consumption and a
substitution effect that increases consumption and decreases leisure. Because less leisure means
more work, a person will work more only if the substitution effect outweighs the income effect.
412 ) Chapter 21/The Theory of Consumer Choice
Questions for Review
1.
Figure 4 shows the consumer's budget constraint. The intercept on the horizontal axis shows how
much cheese the consumer could buy if she bought only cheese; with income of $3,000 and the
price of cheese $6 a pound, she could buy 500 pounds of cheese. The intercept on the vertical
axis shows how much wine the consumer could buy if she bought only wine; with income of
$3,000 and the price of wine $3 a glass, she could buy 1,000 glasses of wine. With cheese on the
horizontal axis and wine on the vertical axis, the budget constraint has a slope of -1,000/500 = 2. Note that if you had put wine on the horizontal axis and cheese on the vertical axis, the
budget constraint would have a slope of -500/1,000 = -1/2.
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Figure 4
2.
Figure 5 shows a consumer's indifference curves for wine and cheese. Four properties of these
indifference curves are: (1) higher indifference curves are preferred to lower ones because more
is preferred to less; (2) indifference curves are downward sloping because if the quantity of wine
is reduced, the quantity of cheese must increase for the consumer to be equally happy; (3)
indifference curves do not cross because a consumer prefers more to less; and (4) indifference
curves are bowed inward because a consumer is more willing to trade away wine if she has a lot
of it and less willing to trade away cheese if she has little of it.
Chapter 21/The Theory of Consumer Choice ) 413
Figure 5
3.
4.
In Figure 5, the marginal rate of substitution (MRS) of one point on an indifference curve is
shown. The marginal rate of substitution shows the amount of wine the consumer would be
willing to give up to get one more pound of cheese.
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Figure 6 shows the consumer's budget constraint and indifference curves for wine and cheese.
The consumer's optimum consumption choice is shown as w* and c*. Because the marginal rate
of substitution equals the relative price of the two goods at the optimum, the marginal rate of
substitution is $6/$3 = 2.
Figure 6
414 ) Chapter 21/The Theory of Consumer Choice
Figure 7
5.
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Figure 7 shows the effect of an increase in income. The rise in income shifts the budget
constraint out from BC1 to BC2. If both wine and cheese are normal goods, consumption of both
increases. If cheese is an inferior good, the increase in income causes the consumption of cheese
to decline, as shown in Figure 8.
Figure 8
Chapter 21/The Theory of Consumer Choice ) 415
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Figure 9
6.
7.
A rise in the price of cheese from $6 to $10 a pound makes the horizontal intercept of the budget
line decline from 500 to 300, as shown in Figure 9. The consumer's budget constraint shifts from
BC1 to BC2 and her optimal choice changes from point A (c1 cheese, w1 wine) to point B (c2
cheese, w2 wine). To decompose this change into income and substitution effects, we draw in
budget constraint BC3, which is parallel to BC2 but tangent to the consumer's initial indifference
curve at point C. The movement from point A to C represents the substitution effect. Because
cheese became more expensive, the consumer substitutes wine for cheese as she moves from
point A to C. The movement from point C to B represents an income effect. The rise in the price
of cheese results in an effective decline in income.
An increase in the price of cheese could induce a consumer to buy more cheese if cheese is a
Giffen good. In that case, the income effect of the rise in the price of cheese induces the
consumer to buy more cheese because cheese is an inferior good. If the income effect is bigger
than the substitution effect (which induces the consumer to buy less cheese), the consumer
would buy more cheese.
416 ) Chapter 21/The Theory of Consumer Choice
Problems and Applications
1.
a.
Figure 10 shows the effect of the frost on Jennifer's budget constraint. Because the price
of coffee rises, her budget constraint swivels from BC1 to BC2.
b.
If the substitution effect outweighs the income effect for croissants, Jennifer buys more
croissants and less coffee, as shown in Figure 10. She moves from point A to point B.
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Figure 10
c.
If the income effect outweighs the substitution effect for croissants, Jennifer buys fewer
croissants and less coffee, moving from point A to point B in Figure 11.
Figure 11
2.
a.
Skis and ski bindings are complements. Coke and Pepsi are substitutes.
b.
Indifference curves between Coke and Pepsi are fairly straight, because there is little to
distinguish them, so they are nearly perfect substitutes. Indifference curves between skis
and ski bindings are very bowed, because they are complements.
Chapter 21/The Theory of Consumer Choice ) 417
3.
c.
A consumer will respond more to a change in the relative price of Coke and Pepsi,
possibly switching completely from one to the other if the price changes.
a.
Cheese and crackers cannot both be inferior goods, because if Mario's income rises he
must consume more of something.
b.
If the price of cheese falls, the substitution effect means Mario will consume more cheese
and fewer crackers. The income effect means Mario will consume more cheese (because
cheese is a normal good) and fewer crackers (because crackers are an inferior good). So,
both effects lead Mario to consume more cheese and fewer crackers.
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Figure 12
4.
a.
Figure 12 shows Jim's budget constraint. The vertical intercept is 50 quarts of milk,
because if Jim spent all his money on milk he would buy $100/$2 = 50 quarts of it. The
horizontal intercept is 25 dozen cookies, because if Jim spent all his money on cookies he
would buy $100/$4 = 25 dozen cookies.
b.
If Jim's salary rises by 10 percent to $110 and the prices of milk and cookies rise by 10
percent to $2.20 and $4.40, Jim's budget constraint would be unchanged. Note that
$110/$2.20 = 50 and $110/$4.40 = 25, so the intercepts of the new budget constraint
would be the same as the old budget constraint. Because the budget constraint is
unchanged, Jim's optimal consumption is unchanged.
418 ) Chapter 21/The Theory of Consumer Choice
Figure 13
5.
a.
Figure 14
Budget constraint BC1 in Figure 13 shows the budget constraint if you pay no taxes.
Budget constraint BC2 shows the budget constraint with a 15 percent tax.
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b.
Figure 14 shows indifference curves for which a person will work more as a result of the
tax because the income effect (less leisure) outweighs the substitution effect (more
leisure), so there is less leisure overall. Figure 15 shows indifference curves for which a
person will work fewer hours as a result of the tax because the income effect (less
leisure) is smaller than the substitution effect (more leisure), so there is more leisure
overall. Figure 16 shows indifference curves for which a person will work the same
number of hours after the tax because the income effect (less leisure) equals the
substitution effect (more leisure), so there is the same amount of leisure overall.
Figure 15
Figure 16
Chapter 21/The Theory of Consumer Choice ) 419
6.
Figure 17 shows Sarah's budget constraints and indifference curves if she earns $6 (BC1), $8
(BC2), and $10 (BC3) per hour. At a wage of $6 per hour, she works 100 – L6 hours; at a wage of
$8 per hour, she works 100 – L8 hours; and at a wage of $10 per hour, she works 100 – L10
hours. Because the labor supply curve is upward sloping when the wage is between $6 and $8
per hour, L6 > L8; because the labor supply curve is backward sloping when the wage is between
$8 and $10 per hour, L10 > L8.
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Figure 17
7.
Figure 18
Figure 18 shows the indifference curve between leisure and consumption that determines how
much a person works. An increase in the wage leads to both an income effect and a substitution
effect. The higher wage makes the budget constraint steeper, so the substitution effect increases
consumption and reduces leisure. But the higher wage has an income effect that increases both
consumption and leisure if both are normal goods. The only way that consumption could
decrease when the wage increased would be if consumption is an inferior good and if the
negative income effect outweighs the positive substitution effect. This could happen for a person
who really placed an exceptionally high value on leisure.
420 ) Chapter 21/The Theory of Consumer Choice
Figure 19
8.
a.
Figure 20
Figure 19 shows the situation in which your salary increases from $30,000 to $40,000.
With numbers shown in thousands of dollars in the figure, your initial budget constraint,
BC1, has a horizontal intercept of 30, because you could spend all your income when
young. The vertical intercept is 31.5, because if you spent nothing when young and
saved all your income, earning 5 percent interest, you would have $31,500 to spend
when old. If your salary increases to $40,000, your budget constraint shifts out in a
parallel fashion, with intercepts of 40 and 42, respectively. This is an income effect only,
so if consumption when young and old are both normal goods, you will spend more in
both periods.
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b.
9.
If the interest rate on your bank account rises to 8 percent, your budget constraint
rotates. If you spend all your income when young, you will spend just $30,000, as
before. But if you save all your income, your old-age consumption increases to $30,000 x
1.08 = $32,400, compared to $31,500 before. As Figure 20 indicates, the steeper budget
line leads you to substitute future consumption for current consumption. But the income
effect of the higher return on your saving leads you to want to increase both future and
current consumption if both are normal goods. The result is that your consumption when
old certainly rises and your consumption when young could increase or decrease,
depending on whether the income or substitution effect dominates.
The decline in the interest rate on savings has both income and substitution effects, because it
causes the budget constraint to rotate. Because consumption when old effectively becomes more
expensive relative to consumption when young, there is a substitution effect that increases
consumption when young and decreases consumption when old. The lower interest rate also
leads to a negative income effect, causing both consumption when young and consumption when
old to decline if both are normal goods. Combining both effects, consumption when old definitely
declines and consumption when young might rise or fall, depending on whether the income or
substitution effect is stronger.
Chapter 21/The Theory of Consumer Choice ) 421
10.
a.
Figure 21 shows the budget constraint. The initial budget line is shown as BL1. If all
hours are spent raising children, 10 children can be raised. If all hours are spent working,
$2,000,000 can be earned for consumption. The individual maximizes utility by choosing
K1 children and a consumption level of C1.
Consumption
(millions of dollars)
BL2
2
C1
U1
BL1
K1
10
Number of
Children
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Figure 21
11.
b.
If the wage rises, the budget line rotates to BL2 in Figure 21. The budget line is now
steeper indicating the higher opportunity cost of raising a child. The substitution of this
increase in the wage will mean a rise in consumption and a decline in the number of
children. Assuming that both children and consumption are normal goods, the income
effect of the increased wage will mean a rise in both children and consumption. The full
effect on consumption is positive, but the end effect on children depends on the relative
sizes of the income and substitution effects.
c.
If the number of children declines as incomes rise, the substitution effect must outweigh
the income effect.
If consumers do not buy less of a good when their incomes rise, the good in question must be a
normal good. For a normal good, the income and substitution effects both imply that the
consumer will buy less if the price rises.
422 ) Chapter 21/The Theory of Consumer Choice
Figure 22
12.
a.
Figure 22 shows the effects of the welfare program. Without the program, the budget
constraint would begin on the horizontal axis at point Lmax when the family earns no labor
income and would have a slope equal to the wage rate. The program provides income of
a certain amount if the family earns no labor income, shown as the point A on the figure.
Then, if income is earned, the welfare payment is reduced, so the slope of the budget
line is less than the slope of the budget line without welfare. At the point where the two
budget lines meet, the welfare program provides no further support.
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13.
14.
b.
The figure shows how indifference curves could be shaped, indicating a reduction in the
number of hours worked by the family because of the welfare program. Because the
welfare budget constraint is flatter, there is a substitution effect away from consumption
and toward leisure. Because the welfare budget constraint is farther from the origin,
there is an income effect that increases both consumption and leisure, if both are normal
goods. The overall effect is that the change in consumption is ambiguous and the family
will want to have more leisure; hence, it will reduce its labor supply.
c.
There is no doubt that the family's well-being is increased, because the welfare program
gives them consumption and leisure opportunities that were not available before and
they end up on a higher indifference curve.
a.
A lower tax rate would give rise to income and substitution effects on a person's choice
of consumption and leisure. The income effect would increase both consumption and
leisure, if both goods were normal goods, because the reduction in the tax rate leaves
more after-tax income. The lower tax rate would increase the slope of the budget
constraint, so the substitution effect would increase consumption and decrease leisure.
The net result is an increase in consumption and an ambiguous effect on leisure, and
thus an ambiguous effect on labor supply.
b.
An increase in the amount on which no tax is owed would be a pure income effect. If
both consumption and leisure are normal goods, both would increase, so labor supply
would decrease.
a.
If a person's utility depends on the lowest level of consumption during her two periods of
life, then her indifference curves between consumption when young and consumption
Chapter 21/The Theory of Consumer Choice ) 423
when old will be right angles, with the angle occurring where consumption in the two
periods are equal, as shown in Figure 23.
b.
The budget constraint, BC1, is shown in the figure. Note that the optimum occurs where
the budget constraint just hits one of the right-angled indifference curves.
c.
An increase in the interest rate shifts the budget constraint to BC2. Because (at the
optimum) consumption when young must equal consumption when old, the person
increases consumption in both periods. Thus the person saves less even though the
interest rate increased. In this case, there is no substitution effect from the higher
interest rate, because of the shape of the indifference curves. The only effect is an
income effect, leading the person to increase consumption in both periods.
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Figure 23
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22
FRONTIERS OF
MICROECONOMICS
WHAT’S NEW IN THE FOURTH EDITION:
There is a new Case Study on “Corporate Management.” There are also two new In the News boxes on
“The Fruits of Moral Hazard” and “The Psychology of Saving.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
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¾
how to examine problems caused by asymmetric information.
¾
the market solutions to asymmetric information.
¾
why democratic voting systems may not represent the preferences of society.
¾
why people may not always behave as rational maximizers.
CONTEXT AND PURPOSE:
Chapter 22 is the last chapter in the microeconomics portion of the text. It is the second of two unrelated
chapters that introduce students to advanced topics in microeconomics. These two chapters are intended
to whet their appetites for further study in economics.
The purpose of Chapter 22 is to give students a taste of three topics on the frontier of
microeconomic research. The first topic addressed is asymmetric information, a situation when one
person in an economic relationship has more relevant knowledge than the other person does. The second
topic is political economy, the application of economic tools to the understanding of the functioning of
government. The third topic addressed is behavioral economics, the introduction of psychology into the
study of economic issues.
KEY POINTS:
1. In many economic transactions, information is asymmetric. When there are hidden actions, principals
may be concerned that agents suffer from the problem of moral hazard. When there are hidden
425
426 ) Chapter 22/Frontiers of Microeconomics
characteristics, buyers may be concerned about the problem of adverse selection among the sellers.
Private markets sometimes deal with asymmetric information with signaling and screening.
2. Although government policy can sometimes improve market outcomes, governments are themselves
imperfect institutions. The Condorcet paradox shows that the majority rule fails to produce transitive
preferences for society, and the Arrow impossibility theorem shows that no voting scheme will be
perfect. In many situations, democratic institutions will produce the outcome desired by the median
voter, regardless of the preferences of the rest of the electorate. Moreover, the individuals who set
government policy may be motivated by self-interest rather than national interest.
3. The study of psychology and economics reveals that human decision making is more complex than is
assumed in conventional economic theory. People are not always rational, they care about the
fairness of economic outcomes (even to their own detriment), and they can be inconsistent over
time.
CHAPTER OUTLINE:
This is a great chapter to get students interested in further study of economics. It is
important for the students to learn that economics is a growing and developing
science and that economists are always looking for new areas to study and new
phenomena to explain.
I.
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Asymmetric Information
A.
Many times in life, one person holds more knowledge about what is going on than
another. Such a difference in access to relevant information is known as an information
asymmetry.
B.
Examples
1.
A worker knows more than his employer about the level of his work effort. This
is an example of a hidden action.
2.
A seller of a used car knows more than the buyer does about the car's condition.
This is an example of a hidden characteristic.
C.
When there is asymmetric information, the party without the relevant knowledge would
like to have such knowledge, but the other party may have an incentive to conceal it.
D.
Hidden Actions: Principals, Agents, and Moral Hazard
1.
Important Definitions
a.
Definition of moral hazard: the tendency of a person who is
imperfectly monitored to engage in dishonest or otherwise
undesirable behavior.
b.
Definition of agent: a person who is performing an act for another
person, called the principal.
Chapter 22/Frontiers of Microeconomics ) 427
c.
2.
3.
Definition of principal: a person for whom another person, called
the agent, is performing some act.
The employment relationship is the classic example.
a.
Workers (agents) may be tempted to shirk their work-related
responsibilities because their employers (the principals) do not monitor
their behavior closely.
b.
Employers can respond by providing better monitoring, paying higher
wages, or delaying part of the worker's pay until later in the worker's
life.
Case Study: Corporate Management
a.
From an economic standpoint, the most important feature of the
corporate form of organization is the separation of ownership and
control.
b.
This creates a principal–agent problem where the shareholders are the
principals and the managers are the agents.
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E.
c.
Managers’ goals may not always coincide with profit maximization.
d.
As a result, many managers are provided compensation packages that
provide incentives to act in the best interest of corporate profits.
Hidden Characteristics: Adverse Selection and the Lemons Problem
1.
Definition of adverse selection: the tendency for the mix of unobserved
attributes to become undesirable from the standpoint of an uninformed
party.
2.
Examples include the used car market, the labor market, and the market for
insurance.
3.
When markets suffer from adverse selection, the invisible hand does not
necessarily work well.
4.
a.
In the used car market, owners of "cherry" or "plum" cars may choose to
keep them rather than sell them at a low price.
b.
In the labor market, wages may be stuck at a level above the equilibrium
wage, resulting in unemployment.
c.
In insurance markets, buyers with low risk may decline to purchase
insurance because the price is too high.
In the News: The Fruits of Moral Hazard
a.
Corporate executives that are caught taking advantage of the
shareholders face long prison sentences.
428 ) Chapter 22/Frontiers of Microeconomics
b.
F.
This is an article from The Wall Street Journal discussing some recent
cases of corporate fraud.
Signaling to Convey Private Information
1.
Definition of signaling: an action taken by an informed party to reveal
private information to an uninformed party.
2.
Examples of Signaling
a.
Firms may spend money on advertising to signal the high quality of their
products.
b.
Students may spend time in school to signal that they are high-ability
individuals.
3.
For a signal to be effective, it must be costly. However, it must be less costly (or
more beneficial) to the person or firm with the higher-quality product.
4.
Case Study: Gifts as Signals
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G.
H.
a.
Because people know their own preferences better than anyone else, we
would expect that they would prefer cash gifts.
b.
However, the ability to choose the right gift for someone may serve as a
signal of an individual's love.
c.
Note that choosing the right gift is costly and the cost depends on how
well the giver knows the recipient (which may be determined as a
measure of the giver's level of interest in the recipient).
Screening to Induce Information Revelation
1.
Definition of screening: an action taken by an uninformed party to
induce an informed party to reveal information.
2.
Examples of Screening
a.
A buyer of a used car may ask to have the car examined by a mechanic
prior to purchase.
b.
An insurance company may offer different policies that would lead safe
or risky drivers to reveal themselves. Safe drivers are likely to prefer
policies with low premiums and high deductibles. Risky drivers are more
likely to prefer policies with higher premiums and low deductibles.
Asymmetric Information and Public Policy
1.
Market failures such as externalities, public goods, imperfect competition, and
poverty show that governments can sometimes improve market outcomes.
2.
Asymmetric information is another reason why market outcomes may be
inefficient.
Chapter 22/Frontiers of Microeconomics ) 429
3.
However, three factors make it difficult for the government to improve the
outcome in some cases.
a.
The private market can sometimes deal with information asymmetries on
its own using a combination of signaling and screening.
b.
The government rarely has more information than the private parties do.
c.
The government is itself an imperfect institution.
Activity 1— A Market for Lemons
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Asymmetric information, signaling, regulation
Prepared instruction sheets and record sheets
50–60 minutes
Works in any size class, although using a larger number of groups
will result in a larger amount of time necessary to complete each
round
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Purpose
This classroom experiment demonstrates how a market for lemons can develop when buyers
have no information on the quality of a product available for sale.
Instructions
Divide the class into seven groups, three sellers and four buyers. Try to keep the groups
separated and make sure that students know not to reveal their cost or value information to
anyone. Pass out instruction sheets and record sheets for each group. Here are the rules for
the first few rounds of the game:
1.
2.
3.
4.
Sellers must decide their product quality and price simultaneously. Each seller can
choose only one product quality but can sell up to two units each period. Sellers'
decisions are recorded and given to the instructor.
Once all of the sellers have made their decisions, the instructor lists the sellers'
product quality and the price on the board.
The instructor draws a number from a hat (1 through 4) and this will be the first
buyer to make a purchase. Buyers decide which firm to buy from based on preferred
quality and price. Buyers may purchase only one unit each period. Once a seller has
sold two units, he or she can sell no more and should be eliminated from the list of
choices.
Profit for sellers will be the difference between the price and the cost (given to them
on their instruction sheets) for each unit sold. Due to rising marginal cost, the cost of
the second unit is $1.00 more than the first. The cost information for each firm is:
Quality 3
Quality 1
Quality 2
Cost of 1st unit
$1.75
$4.95
$11.35
Cost of 2nd unit
$2.75
$5.95
$12.35
430 ) Chapter 22/Frontiers of Microeconomics
5.
For the buyers, consumer surplus will be the difference between the value to the
consumer (given on their instruction sheets) and the price paid. The value for each
buyer is:
Quality 3
Quality 1
Quality 2
Value to the buyer
$5.00
$9.80
$14.50
6.
Once a few rounds have been played, the instructor should announce that he will only
list the sellers' prices on the board. Buyers must base their decisions entirely on price
information.
Points for Discussion
Begin by discussing the results of the rounds where buyers and sellers had complete
information.
1.
2.
3.
Do sellers or buyers benefit from a higher quality of product?
What is the most efficient quality? (Which maximizes total surplus?)
Suppose the market ended up with only Quality 2 products? Would it be efficient for a
regulator to force firms to manufacture Quality 3 products? Why or why not?
Students will generally figure out that Quality 2 maximizes the sum of producer and consumer
surplus in the market. To illustrate this point, the instructor can graph the supply and demand
curves for each quality.
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Once you have discussed the market with full information, start a discussion on the results of
the information asymmetry.
1.
2.
3.
What happened in the market when buyers were unable to distinguish the product
quality?
Why were firms driven to produce the lowest quality?
In reality, is there any way for a firm to reveal the quality of its product?
Most students will reply that the producers were able to take advantage of buyers in this
situation and thus cut product quality. Buyers quickly learned to protect themselves and only
purchased lower priced goods. This led to a market where the only good available for sale is
of the lowest quality.
Students may discuss the ability of a firm to signal its quality through expensive
advertisements or product guarantees and warranties.
II.
Political Economy
A.
The field of political economy applies the methods of economics to study how the
government works.
B.
The Condorcet Paradox
1.
Most advanced societies rely on democratic principles, allowing the majority to
set government policy.
Chapter 22/Frontiers of Microeconomics ) 431
2.
For most policy issues, the number of possible outcomes exceeds two.
3.
Example: Three possible outcomes (A, B, and C) and three voter types (Type 1,
Type 2, and Type 3). The mayor of a town wishes to aggregate the individual
preferences into preferences for society as a whole.
Table 1
Voter Type
Type 1
Type 2
Type 3
Percent of Electorate
35
45
20
First Choice
A
B
C
Second Choice
B
C
A
Third Choice
C
A
B
a.
In pairwise majority voting, A would beat B, B would beat C, and C
would beat A.
b.
This violates transitivity. We generally expect that A is preferred to B and
B is preferred to C, then A would be preferred to C.
c.
Definition of Condorcet paradox: the failure of majority rule to
produce transitive preferences for society.
d.
This implies that the order on which things are voted can determine the
result.
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432 ) Chapter 22/Frontiers of Microeconomics
Activity 2 — The Voting Paradox
Type:
Topics:
Materials needed:
Time:
Class limitations:
In-class demonstration
Condorcet paradox
None
15–20 minutes
Works in any size class
Purpose
Students can easily see how a ranking system involving three choices can lead to a result that
is inconsistent with transitivity.
Instructions
Choose three topics that you have recently discussed in class. Label them A, B, and C. Ask
students to rank the three from most interesting to least interesting on a sheet of paper and
pass it to the instructor.
Tally the ranking choices. There are six possibilities: ABC, BCA, CAB, ACB, CBA, and BAC.
Write the tallies on the board.
Compare choice A with choice B. Add up the number of students who reported that they
preferred A to B and those who preferred B to A. Report the score and the "winner" to the
class.
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Repeat for B and C.
If it turns out that A is preferred to B and B is preferred to C (or B is preferred to A and C is
preferred to B), ask the students if they can predict whether or not A will beat C. Most will
assume that preferences will be transitive.
Tally the results for A and C.
If it turns out that preferences are in fact transitive, discuss how easy it would have been for
the results to be a little different. (For example, "If only two more students had preferred A to
B . . .")
C.
Arrow's Impossibility Theorem
1.
In a 1951 book, economist Kenneth Arrow examined if a perfect voting system
exists.
2.
He assumes that society wants a voting scheme that satisfies social properties.
3.
a.
Unanimity.
b.
Transitivity.
c.
Independence of irrelevant alternatives.
d.
No dictators.
Arrow proved that no voting system could have all of these properties.
Chapter 22/Frontiers of Microeconomics ) 433
D.
4.
Definition of Arrow impossibility theorem: a mathematical result
showing that, under certain assumed conditions, there is no scheme for
aggregating individual preferences into a valid set of social
preferences.
5.
Arrow’s impossibility theorem implies that no matter what voting scheme society
adopts for aggregating the preferences of its members, in some way it will be
flawed as a mechanism for social choice.
The Median Voter Is King
Figure 1
1.
Example: A society is deciding how much money to spend on a public good. Each
voter has a most-preferred budget and prefers outcomes closer to his preferred
budget.
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2.
E.
Definition of median voter theorem: a mathematical result showing that
if voters are choosing a point along a line and each voter wants the
point closest to his preferred point, then majority rule will pick the
most preferred point of the median voter.
a.
The median voter is the voter exactly in the middle of the distribution.
b.
On Figure 1, the median voter wants a budget of $10 billion.
3.
One implication of the median voter theorem is that if two political candidates
are each trying to maximize their chance of election, they will both move their
positions toward the median voter.
4.
Another implication of the median voter theorem is that minority views are not
given much weight.
5.
In the News: Farm Policy and Politics
a.
In 2001, the U.S. Congress passed the Farm Security Act.
b.
This is a column by humorist Dave Barry that discusses specific pieces of
this legislation.
Politicians Are People Too
1.
Politicians may be self-interested.
434 ) Chapter 22/Frontiers of Microeconomics
2.
III.
Some politicians may be motivated by desire for reelection and others may be
motivated by greed.
Behavioral Economics
A.
Economics and psychology are both studies of human behavior.
B.
Behavioral economics is a relatively new field in economics where economists make use
of basic psychological insights into human behavior.
C.
People Aren’t Always Rational
1.
Economists assume that human beings are always rational.
a.
Firm managers maximize profit.
b.
Consumers maximize utility.
c.
Given constraints that they face, these individuals make decisions by
rationally weighing all costs and benefits.
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2.
3.
D.
Real people are often more complex than economists assume.
a.
They can be forgetful, impulsive, confused, emotional, and shortsighted.
b.
These imperfections suggest that humans should not be viewed as
rational maximizers but as “satisficers,” where they choose options that
are simply “good enough.”
Studies of human decisionmaking have found several systematic mistakes that
people make.
a.
People are overconfident.
b.
People give too much weight to a small number of vivid observations.
c.
People are reluctant to change their minds.
People Care about Fairness
1.
Example: the ultimatum game.
a.
Two volunteers are told they are going to play a game and could win a
total of $100.
b.
The game begins with a coin toss, which is used to assign the volunteers
to the roles of Player A and Player B.
c.
Player A’s job is to propose a division of the prize between himself and
the other player.
d.
After Player A makes his proposal, Player B decides whether to accept or
reject it.
Chapter 22/Frontiers of Microeconomics ) 435
e.
E.
If Player B accepts the proposal, both players are paid according to the
proposal. If Player B rejects the proposal, both players receive nothing.
2.
Conventional economic theory suggests that Player A should know that if he
offers $1 to Player B and keeps $99 for himself, Player B should accept it ($1 is
greater than $0).
3.
In reality, when the offer made to Player B is small, Player B often rejects it.
4.
Knowing this, people in the role of Player A often offer a more substantial portion
of the money to Player B.
5.
This implies that people may be driven by a sense of fairness.
People Are Inconsistent over Time
1.
Many times in life, people make plans for themselves but then fail to follow
through.
2.
The desire for instant gratification can induce a decisionmaker to abandon his
past plan.
3.
An important implication is that people will try to find ways to commit their
future selves to following through on their plans.
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F.
In the News: The Psychology of Saving
1.
Economists interested in behavioral economics have devoted much energy to
studying why people do not save.
2.
This is an article from The New York Times discussing recent research that
suggests that Americans would choose to save more if saving was on the path of
least resistance.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
The answers to the Quick Quizzes can also be found near the end of the textbook.
1.
Buyers of life insurance will likely have higher than the average death rates. Two reasons for this
are moral hazard and adverse selection.
Moral hazard is the tendency of a person who is imperfectly monitored to engage in dishonest or
otherwise undesirable behavior. After purchasing insurance, an insured person may engage in
riskier behavior than do people who are not insured.
Adverse selection is the tendency for the mix of unobserved attributes to become undesirable
from the standpoint of an uninformed party. In this case, those with higher risk of death are
more likely to want to buy insurance. As a result, the price of life insurance will reflect the costs
436 ) Chapter 22/Frontiers of Microeconomics
of a riskier-than-average person. Buyers with low risk of death may find the price of life
insurance too high and may choose not to purchase it.
A life insurance company can mitigate moral hazard by trying to monitor behavior better and
charging higher rates to those who engage in risky behavior (such as smoking). It can mitigate
adverse selection by trying to collect better information on applicants; for example, it may require
that all applicants submit to a medical examination before issuing insurance.
2.
According to the median voter theorem, if each voter chooses a point closest to his preferred
point, the district vote will reflect the preferences of the median voter. Therefore, the district will
end up with a student-teacher ratio of 10:1.
3.
Human decision making can differ from the rational human being of conventional economic
theory in three important ways: (1) people aren’t always rational, (2) people care about fairness,
and (3) people are inconsistent over time.
Questions for Review
1.
2.
3.
Moral hazard is the tendency of a person who is imperfectly monitored to engage in dishonest or
otherwise undesirable behavior. To reduce the severity of this problem, an employer may
respond with (1) better monitoring, (2) paying efficiency wages, or (3) delaying part of a
worker’s compensation to later in his work life.
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Adverse selection is the tendency for the mix of unobserved attributes to become undesirable
from the standpoint of an uninformed party. Examples of markets in which adverse selection
might be a problem include the market for used cars and the market for insurance.
Signaling is an action taken by an informed party to reveal private information to an uninformed
party. Job applicants may use a college diploma as a signal of ability. Screening is an action
taken by an uninformed party to induce an informed party to reveal information. A life insurance
company may require applicants to submit to a health examination so that the company will have
more information on the person’s risk of death.
4.
Condorcet noticed that the majority rule will fail to produce transitive properties for society.
5.
The median voter’s preferences will beat out any other proposal in a two-way race because the
median voter will have more than half of the voters on his side.
6.
Two volunteers are chosen and a coin toss determines which volunteer is Player A and which is
Player B. Player A proposes a split of a sum of money and then Player B decides whether to
accept or reject the proposal. If Player B accepts, the sum of money is divided as outlined in the
proposal. If Player B rejects the proposal, each player gets nothing.
Conventional economic theory predicts that Player A will offer only $1 to Player B and keep the
remainder for himself. This is predicted to occur because Player A knows that Player B will be
better off with $1 than with $0. However, in reality, Player B generally rejects small proposals
that he considers unfair. If Player A considers this, he will likely offer Player B a more substantial
amount.
Chapter 22/Frontiers of Microeconomics ) 437
Problems and Applications
1.
2.
3.
4.
a.
The landlord is the principal and the tenant is the agent. There is asymmetric information
because the landlord does not know how well the tenant will take care of the property.
Having a tenant pay a security deposit increases the likelihood that the tenant will take
care of the property in order to receive his deposit back when he vacates the property.
b.
The stockholders of the firm (the owners) are the principals and the top executives are
the agents. The firm’s owners do not know in advance how well the top executives will
perform their duties. Tying some of the executives’ compensation to the value of the firm
provides incentive for the executives to work hard to increase the value of the firm.
c.
The insurance company is the principal and the customer is the agent. Insurance
companies do not know whether the car owner is likely to leave the vehicle parked with
the keys in it or park it in a high crime area. Individuals who will go to the trouble of
installing anti-theft equipment are more likely to take good care of their vehicles.
Offering a discount on insurance premiums will induce car owners to install such devices.
Individuals who are relatively healthy may decide to forgo purchasing the policy if the premium
rises. Thus, the insurance company is left with only those policyholders who are relatively
unhealthy. This means that the firm’s revenues may in fact fall, but its costs could remain the
same. Therefore, the firm’s profits could fall.
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Saying "I love you" is likely not a good signal. To be an effective signal, the signal must be costly.
In fact, the signal must be less costly, or more beneficial, to the person with the higher-quality
product. Simply professing one's love does not meet this requirement.
If insurance companies were not allowed to determine if applicants are HIV-positive, more
individuals who are HIV-positive would be able to purchase insurance, but that insurance would
be very expensive. Covering these individuals would raise the cost of providing health insurance
and the company would have to raise premiums for all. Thus, individuals who are not HIVpositive would be forced to pay more for health insurance and may drop coverage. Insurance
companies would be left insuring only those who are ill (including those who are HIV-positive),
increasing the adverse selection problem. The number of individuals without health insurance
would likely rise as a result.
5.
If the needy are given cash, they can use the cash to purchase whatever they most desire. This
will increase their utility by more than if the government predetermines what they “need.”
However, if the government is worried about how these individuals may spend the cash and
wants to ensure that the needy receive proper nutrition, they may want to provide free meals at
a soup kitchen instead.
6.
Ken is violating the property of independence of irrelevant alternatives. Adding a choice of
strawberry after he chooses vanilla over chocolate should not induce him to change his mind and
prefer chocolate.
7.
a.
If the three friends use a Borda count, the Chinese restaurant gets the most votes (10);
the Italian restaurant gets 9 votes; the Mexican restaurant gets 7 votes; and the French
restaurant gets 4 votes.
b.
In this scenario, the Italian restaurant gets 5 votes and the Chinese restaurant gets 4
votes. Thus, they will choose to eat at the Italian restaurant.
438 ) Chapter 22/Frontiers of Microeconomics
8.
9.
c.
This voting violates the assumption of independence of irrelevant alternatives. The
presence of the Mexican and French restaurants should not alter the group’s preferences
between the Italian and Chinese restaurants.
a.
There would be a tie between the three television shows, with 6 votes each.
b.
In a vote between Friends and Seinfeld, Friends would win. In a vote between Friends
and Scrubs, Scrubs would win. Thus, Elaine’s first choice (Scrubs) would win.
c.
No. He will want to vote between Seinfeld and Scrubs first, with the winner then
competing in a second vote with Friends. That way, his preferred choice (Friends) would
win.
d.
If George says he prefers Seinfeld over Friends, Seinfeld will then compete in a vote
against Scrubs (which it will win). This way, George will not have to watch his least
preferred show (Scrubs).
a.
The efficient number of movies is three. Total surplus would be the sum of the
roommates’ willingness to pay (19 + 13 + 9 = 41) minus the cost of the movies (8 + 8 +
8 = 24) which is 17.
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b.
Quentin would want 4 movies; Spike would prefer 3; Ridley wants 2; Martin wants 1; and
Steven does not want to rent a movie.
c.
The preference of the median roommate (Ridley) is 2 movies.
d.
Quentin and Spike would vote for 3 movies, but the other three roommates would vote
for 2 movies.
e.
No. Any other option besides 2 movies would get fewer votes.
f.
No. The provision of the public good will likely be determined by the preferences of the
median voter. This may or may not be the efficient outcome.
10.
It is possible that a minority of voters is willing to contribute large sums of money to a candidate
who supports their viewpoint. Running a political campaign is very expensive and a candidate
may be able to gain support through expensive advertising. Thus, the candidate may choose to
support the views of those individuals who can help finance his campaign.
11.
More than likely, the two stands will locate at the center of the beach. Thus, they will always be
closest for at least half of the beach goers.
12.
An earthquake occurring in California does not increase the probability that another will occur.
Thus, nothing that affects the benefits from such insurance has really changed. The individuals
are simply putting more emphasis than necessary on the event. However, if it were true that the
individuals had no idea of the possible risks until the earthquake occurred, then purchasing the
insurance would be a rational thing to do.
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