Salvatore/Microeconomics, 5th edition /Web Examples
WEB SITE CONTENTS
Chapter 1: Fewer Guns Means a Lot More Butter
Chapter 1: Even the IBM PC and the Boeing 777 Are Not All American!
Chapter 2: Changes in Supply and Demand Cause Large Swings in Copper Prices
Chapter 3: Happiness and Life Satisfaction over Time in the U.S. and the U.K.
Chapter 4: The Human Development Index—A Better Measure of the Standard of Living
Chapter 5: Estimation of the Demand for Oranges by Market Experiment
Chapter 6: Returns on U.S. Asssets Are Higher for More Risky Investments
Chapter 7: How Motorola Stumbled and Failed to Avoid Diseconomies of Scale
Chapter 8: To Reduce Costs, Firms Often Look Far Afield
Chapter 9: The Russian Wheat Deal and U.S. Wheat Prices
Chapter 10: Restrictions on Competition in the Pricing of Milk in New York City and the Nation
Chapter 11: The Monopolistically Competitive Restaurant Market
Chapter 12: The Objective and Strategy of Firms in the Cigarette Industry
Chapter 13: Transfer Pricing
Chapter 14: The Glut of Lawyers and Doctors in the United States
Chapter 15: Change in the Occupational Distribution of the U.S. Labor Force: 1990–1999
Chapter 16: Rates of Return on U.S. and Foreign Share Price
Chapter 17: Exchange in POW Camps
Chapter 18: The Fable of the Apples and the Bees
Chapter 19: Information and the Limits to Workers Privacy
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Web Example 1-1
Fewer Guns Means a Lot More Butter
With the collapse of communism in the former Soviet Union and its virtual removal as a
military threat, the United States reaped a sizable “peace dividend”; that is, U.S. military
expenditures (which in 1990 were 26% of the government’s total budget) were reduced
sharply and redirected toward the private sector and other forms of government spending.
Over a decade, the savings from military expenditures amounted to as much as $150 billion
per year. Growth was also stimulated by gradually redeploying toward civilian uses the 30%
of all scientists and engineers previously employed in defense-related research and
production.
There were many conflicting claims on such a peace dividend. Some wanted to use
the money to help the Eastern European countries and the former Soviet republics
restructure their economies to promote democracy. Others wanted to use it to improve
health, education, and infrastructure in this country. Still others wanted to use it to reduce
the immense federal deficit; this would reduce public borrowing, lower interest rates, and
stimulate housing and other private investments.
Some thought that using of the peace dividend to improve health, education, and
infrastructure would increase long-term national growth considerably. For example, a billion
dollars could provide comprehensive prenatal care to an additional 1.5 million poor pregnant
women or add 400,000 children to the Head Start program. It has been estimated that each
dollar spent on Head Start saves almost $5 in welfare, remedial education, and other costs
later. Improving infrastructure would also be productive. According to the Federal
Transportation Department, urban areas waste 2 billion hours a year on highway delays.
Flight delays at 21 primary airports amount to 20,000 hours per year. As it turned out, the
peace dividend was in fact used to do a little of all the above.
The same type of heated discussion arose during the 2000 Presidential election and
afterwards on how to use the huge budget surplus that was developing when the American
economy was growing very rapidly. With sharp and unexpected decline in the growth of the
U.S. economy in 2001 and the huge tax cuts pushed by the newly elected Bush
Administration, the budget surplus all but vanished—and so did the discussion of what to do
with it. What did occur, however, was a major shift in budget priorities: Whereas in 1956
60% of federal spending went for defense and 22% for social security and other payments to
individuals, in 2006 60% went for the latter and 20% for the former.
Source: “$150 Billion a Year—How to Spend It,” New York Times, March 9, 1990, p. 34;
“The Defense Whizzes Making It in Civvies,” Business Week, September 7, 1992, pp.
88-90; Allen Schick, “How the Federal Surplus Happened,” Brookings Review, Winter
2000, pp. 36–39; “President’s Signature Turns Broad Tax Cut, and a Campaign Promise,
Into a Law,” New York Times, June 6, 2001, p. 24; “Bush Projections in Budget Surplus,”
New York Times, August 23, 2001, p. 1; and “The Stubborn Welfare State,” Newsweek,
February 19, 2007, p. 39.
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Web Example 1-2
Even the IBM PC and the Boeing 777 Are Not All American!
The following table shows that of the total manufacturing cost of $860 for the IBM PC in
1985, $625 was for parts and components made abroad (of which, $230 was from U.S.owned plants). Even though all the parts made overseas could be manufactured
domestically, they would have cost more and would have led to higher PC prices in the
United States (and reduced competitiveness of IBM PCs in international markets). In fact,
at the end of 2004, IBM sold its PC business to China’s Lenovo. Similarly, only 13 of the
33 major components of the new Boeing 777 jetliner are made in the United States, 7 are
made in Japan, and another 13 in other countries (Australia, Canada, England, France,
Italy, and South Korea).
Distribution of Manufacturing Costs for the IBM PC in the United States and Abroad
__________________________________________________________________________
Total manufacturing cost:
Portion made abroad:
in U.S.-owned plants
in foreign-owned plants
Distribution of manufacturing costs:
Monochrome monitor
Semiconductors
Semiconductors
Power supply
Graphic printer
Floppy disk drives
Assembly of disk drives
Keyboard
Case and final assembly
$860
$625
$230
$395
(Korea)
(Japan)
(U.S.)
(Japan)
(Japan)
(Singapore)
(U.S.)
(Japan)
(U.S.)
$ 85
105
105
60
160
165
25
50
105
$860
________________________________________________________________________
Sources: “America’s High Tech Crisis,” Business Week, March 11, 1985, pp. 56–67;
Boeing news release 1998; and “IBM Strikes a Deal with Rival Lenovo,” Wall Street
Journal, December 9, 2004, p. A3.
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Web Example 2-1
Changes in Supply and Demand Cause Large Swings in Copper Prices
Copper is an important mineral with a large variety of industrial uses, ranging from
electrical wires, electrical appliances, and computers, and it is used in the construction of
automobiles, homes and offices. In terms of quantities consumed, copper is third among
metals after iron and aluminum. It is its properties of high thermal and electrical
conductivity, malleability, and resistance to corrosion that make a readily available
supply of copper crucial for modern industrial production, and its price is an important
part of the cost of many products. There are, however, substitutes and a change in the
price of copper in relation to the price of its substitutes can lead to the switching from one
mineral to others in production of many products.
Changes in Demand and Supply can explain the sharp decline in the world’s price
of copper from about $1.20 per pound in mid-1997 to $0.62 per pound in mid-2001. The
decline in copper prices during the second half of 1997 was triggered by the serious
financial and economic crisis in South-East Asia (South Korea, Thailand, Malaysia,
Indonesia, and the Philippines), which reduced the world demand for copper. By the
beginning of 1999, the price of copper had reached a low of $0.61 per pound. From then
until the fall of 2000, the price of copper rallied to $0.89 per pound, as the demand for
copper increased with the end of the crisis in South-East Asia and as a result of rapid
growth in the United States (then the world’s largest user of copper). From fall 2000 until
fall 2001, however, copper declined to $0.62 as a result of flat world consumption
(because of the world economic slowdown) in the face of large increases in supply
(rightward shift in the world supply curve) as several new large copper mines in South
America (especially Chile—the largest copper producer in the world) and in Asia started
production. Since then, however, copper prices increased sharply and exceeded $3.50 per
pound in fall 2006 as a result of production problems in various producing countries and
sharply increased demand (especially from China, which has now the largest user,
accounting for about 20% of world consumption).
Despite the recent sharp increase in the price of copper, U.S. mining companies
are facing increasing pressure due to their high production costs, lower-quality copper
ore, and more stringent environmental regulations. In recent years, U.S. Mining
companies have reduced costs by implementing new and cheaper smelting (refining)
techniques and by mergers (so as to eliminate excess capacity). Despite these efforts,
U.S. copper production declined from 2,140 metric tons in 1998 to 1,220 metric tons in
2006, while most other copper producing countries increased theirs (the United States,
however, still remains the world’s second copper producer with 8 percent of world output
after Chile, which has 35 percent of the world market).
Source: “Tough Times in Copper Pits,” New York Times, September 11, 1999, p. C1 and
Daniel E. Eldstein, “Copper,” U.S. Geological Survey Mineral Yearbook (Washington,
D.C.: U.S. Government Printing Office, 2006). See also:
http://minerals.usgs.gov/minerals/pubs/commodity/copper/coppemcs07.pdf.
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Web Example 3-1
Happiness and Life Satisfaction Over Time in the U.S. and the U.K.
The following table shows the proportions of people giving different happiness answers
in the United States and in the United Kingdom over the 1972–1998 period.
Happiness and Life Satisfaction: Averages for Different Periods
a) The proportions of people giving different happiness answers in the United States 1972–98
1972–1976
All - not too happy
All - pretty happy
All - very happy
1977–1982
1982–1987 1988–1993
1994–1998
14%
52
34
12
54
34
12
56
32
10
58
33
12
58
30
Male - not too happy
Male - pretty happy
Male - very happy
14
54
32
12
56
32
13
57
30
9
58
34
11
58
31
Female - not too happy
Female - pretty happy
Female - very happy
13
51
36
12
53
35
12
56
33
11
57
32
13
59
29
White - not too happy
White - pretty happy
White - very happy
12
52
36
11
54
35
11
56
33
9
57
34
11
59
31
Black - not too happy
Black - pretty happy
Black - very happy
26
54
20
23
54
23
21
58
21
18
60
22
21
58
20
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(Continued from the previous page)
b) The proportions of people giving different life-satisfaction answers in Great Britain 1973–98.
1972–1976
1977–1982
1983–1987
1988–1993
1994–1998
All - not at all
All - not very
All - fairly
All - very
4%
11
54
31
4
10
54
32
4
10
55
31
4
10
55
31
3
10
57
31
Male - not at all
Male - not very
Male - fairly
Male - very
4
11
55
30
4
10
55
31
4
10
57
29
4
10
57
29
4
10
58
29
Female - not at all
Female - not very
Female - fairly
Female - very
4
12
53
32
4
10
53
34
3
10
54
32
3
11
54
32
3
9
55
32
Source: D. Blanchflower and A. Oswald, “Well-Being Over Time in Britain and the
USA,” NBER Working Paper 7487, January 2000, p. 19.
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Web Example 4-1
The Human Development Index—A Better Measure the Standard of Living
The United Nations has recently devised a broader and better measure of a nation’s standard of
living than just comparing per capita incomes, called the Human Development Index (HDI). The
HDI is a weighted average of life expectancy (as a measure of the general health conditions in the
nation), an educational index (which includes the adult literacy rate and student enrolment ratio in
the nation), and real per capita income adjusted for differences in the purchasing power of the
dollar (PPP—defined in Example 4–8). The table below shows the three components of the HDI,
as well as the HDI itself for the same 13 countries included in Table 4.3 in Example 4–8. Note that
the PPP per capita incomes shown in the table below are different than those shown in Table 4.3
because of different methods of adjustment.
The table shows that Canada has the highest HDI, followed by Japan, France, United
States, United Kingdom, Italy, and Germany among the developed countries, and Mexico, South
Korea, Russia, Brazil, China and India among developing countries. Note also that the difference
in the HDI among developed and developing countries is much less than if we compare only their
PPP per capita incomes.
Life Expectancy, Education Index, PPP Per Capita Income, and Human Development Index:
Selected Developed and Developing Countries, 2005
______________________________________________________________________________
Life
Human
Expectancy
Education
Per Capita
Development
Country
at Birth
Index
Income
Index
(years)
(PPP US $)
(HDI)
______________________________________________________________________________
1.
2.
3.
4.
5.
6.
7.
Canada
Japan
France
United States
United Kingdom
Italy
Germany
80.3
82.3
80.2
77.9
79.0
80.3
79.1
0.99
0.95
0.98
0.97
0.97
0.96
0.95
$33,375
31,267
30,386
41,890
33,238
28,529
29,461
0.961
0.953
0.952
0.951
0.946
0.941
0.935
9. Mexico
75.6
0.86
10,751
0.829
8. S. Korea
77.9
0.98
22,029
0.921
10. Russia
65.0
0.96
10,845
0.802
10. Brazil
71.7
0.88
8,402
0.800
11. China
75.9
0.84
6,757
0.777
12. India
63.7
0.62
3,452
0.619
______________________________________________________________________________
Source: United Nations Development Program, Human Development Report. New York:
Oxford University Press, 2007/2008, pp. 229–232.
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Web Example 5-1
Estimation of the Demand for Oranges by Market Experiment
Researchers at the University of Florida conducted a market experiment in Grand Rapids,
Michigan, in 1962 to determine the price elasticity and the cross-price elasticity of
demand for three types of Valencia oranges: those from the Indian River district of
Florida, those from the interior district of Florida, and those from California. Grand
Rapids was chosen as the site for the market experiment because its size, demographic
characteristics, and economic base were representative of other midwestern markets for
oranges.
Nine supermarkets participated in the experiment, which involved changing the price
of the three types of oranges, each day, for 31 consecutive days and recording the
quantity sold of each variety. The price changes ranged within 16 cents, in 4-cent
increments, around the price of oranges that prevailed in the market at the time of the
study. More than 9,250 dozen oranges were sold in the nine supermarkets during the 31
days of the experiment. Each of the participating supermarkets was provided with an
adequate supply of each type of orange so that supply effects could be ignored. The
length of the experiment was also sufficiently short so as to ensure no change in tastes,
incomes, population, the rate of inflation, and determinants of demand other than price.
The results, summarized in the following table, indicate that the price elasticity of
demand for all three types of oranges was fairly high (the boldface numbers in the main
diagonal of the table). For example, the price elasticity of demand for the Indian River
oranges of -3.07 indicates that a 1 percent increase in their price leads to a 3.07 percent
decline in their quantity demanded. More interestingly, the off-diagonal entries in the
table show that while the cross-price elasticities of demand between the two types of
Florida oranges were larger than 1, they were close to zero with respect to the California
oranges. In other words, while consumers regarded the two types of Florida oranges as
close substitutes, they did not view the California oranges as such. In pricing their
oranges, therefore, producers of each of the two Florida varieties would have to carefully
consider the price of the other (as consumers switch readily among them as a result of
price changes) but need not be much concerned about the price of California oranges.
Price Elasticity and Cross Price Elasticity of Demand for Oranges
________________________________________________________________
Florida
Type of Orange
Indian River
Florida Interior
California
Florida Indian River
-3.07
+1.56
+0.01
Florida Interior
+1.16
-3.01
+0.14
California
+0.18
+0.09
-2.76
________________________________________________________________
Source: M. B. Godwin, W. F. Chapman, and W. T. Hanley, “Competition between Florida and
and California Valencia Oranges in the Fruit Market,” Bulletin 704 (Gainesville: University of
Florida, December 1965).
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Web Example 6-1
Returns on U.S. Assets Are Higher for More Risky Investments
The following table shows the average annual return and standard deviation of the returns
on U.S. stocks, U.S. Treasury bonds, U.S. Treasury bills, gold and silver holdings, as well
as the average annual rate inflation over the period 1990 to 1999.
The table shows that U.S. stocks had the highest average annual return but also
the highest variability of returns or risk, as measured by the standard deviation. U.S.
Treasury bonds and bills had much lower average annual returns but also faced much
lower risk because the probability that the U.S. government goes out of business is
practically nill. U.S. Treasury bills offer lower returns than U.S. Treasury bonds because
the former are more liquid (i.e., mature in less than one year, most commonly three
months, while U.S. Treasury bonds have a maturity of one year or more).
With the annual rate of inflation of 3.2 percent, this means that the average annual
real rate of return on U.S. stocks was 6.8 percent (10.0%–3.2%) over the period 1990–
1999. On the other hand, the average annual real rate of return on U.S. Treasury bonds
and U.S. Treasury bills was, respectively, 1.4 percent and 0.9 percent over the same
period. The average real rate of return on holding gold and silver, however, was negative
(-0.6 and–1.0, respectively). Thus, despite the claims often made that precious metals
(particularly gold) offer the best protection against inflation, their price increased at a
slower rate than the rate of inflation and so their real return was actually negative of the
last decade.
Average Annual Rate of Return and Standard Deviation on U.S. Assets
and Rate of Inflation, 1990–1999
_________________________________________________________
Asset
Annual Rate of Return
Standard Deviation
_________________________________________________________
Stocks
10.0
1.95
Treasury bonds
4.6
0.37
Treasury bills
4.1
0.11
Gold holdings
2.6
0.49
Silver holdings
2.2
0.73
Inflation rate
3.2
0.16
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Source: The Foresight Saga,” The Economist, December 18, 1999, pp. 59-61.
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Web Example 7-1
How Motorola Stumbled and Failed to Avoid Diseconomies of Scale
Motorola, a leader in the worldwide revolution in wireless communications, grew by
leaps and bounds from the mid-1980s to the mid-1990s. In 1995, its revenues were $27
billion (with profits of $1.8 billion), propelling it to the twenty-fourth spot on the Fortune
500 list. In fact, Motorola had been doubling in size every five years (its sales were $10
billion in 1989). The question in 1996 was “Can Motorola keep avoiding excessive
bureaucracy, complacency, and diseconomies of scale as it grows larger and larger?”
That question was answered in the second half of the decade, when Motorola stumbled.
In 2000, Motorola revenues had grown only to $37 billion (with profits of $1.3 billion)
and it had slipped to 109th place in the Fortune 500 list.
Until 1996, Motorola was considered by many to be the best-managed company in
the world. It was described as an icon of innovation, a pioneer of self-directed teams, and
a prince of profits; it wrote the book on decentralization, job training, and promoting
cooperation between labor and management. Motorola was regarded as simply the best in
the world in almost everything it did—including cellular phones, pagers, two-way radios,
semiconductors, and other electronic gadgets. In 1995, Motorola had an incredible 85
percent share of the world market in pagers, a 45 percent share of the world market for
cellular phones, and $6 billion in semiconductor sales (making it the world’s number 3
chip producer, after Intel and NEC), and it generated more than half of its revenues
abroad. Contrary to many other large U.S. firms at the time, this was a large company
that sizzled. From a slowly declining electronics company in the 1970s, Motorola had
become a world technological leader, beating the best of its Japanese competitors—and
in the process becoming an industrial legend and management-books case study.
By 1998, however, it was clear that Motorola had slipped very badly. First, it failed to
anticipate the rapid move to digital technology and so it lost market leadership in cellular
telephones, not only around the world but also on its home turf, to a relative new comer,
Nokia of Finland. Then, came its leadership crisis after its respected chief executive,
George Fisher, left to head Eastman Kodak and Chris Galvin, the unseasoned and less
than brilliant third-generation member of his family to run the company, took over.
Finally, came its ill-fated move into Iridium, the ambitious new satellite world-wide
telephone service, which failed to take off and filed for bankruptcy in August of 1999.
The question is, How could this have happened to a company that until a few years
earlier had been regarded as one of the best companies in the world?
In a nutshell, Motorola simply seemed to have lost its way during the second half of
the 1990s. It had grown arrogant with success, became self-satisfied, and became
sluggish in execution, in a world that had become increasingly competitive and fast.
Motorola’s renowned “warring tribes” culture, which pitted one division against the
other, backfired and became a stumbling block to change and renewal. Since 1998,
Motorola has tried to turn the company around by merging into one unit the cellular,
paging, and the two-way radio
(Continued on the next page)
(Continued from the previous page)
operations, which previously had been separate and beset by warring divisions. Motorola
sold the low-end chip manufacturing operation, laid off more than 48,000 of its 150,000
employees, and shifted more than 3,000 engineers to develop new digital handsets.
Potentially more significant, Motorola tried to move into a new direction, whereby it not
only designed and produced the chips but also designed and developed the software that
ran them, as well as working with customers to develop new products and services.
Specifically, Motorola wanted mobile telephones, two-way pagers, personal organizers,
and other hand-held devices to combine voice and Internet services and in the process,
also regain market leadership in digital cellular telephones in the United States and
around the world. By the end of 2001, Motorola had still not recaptured the market
leadership it had a decade earlier and in fact it incurred its first annual net loss in decades.
After regaining some market share in recent years as a result of the introduction of its
highly successful Razor cellular telephone, Motorola’s market share fell again and
reached 13% of the world market in 2007, while Nokia’s rose to 37%.
Source: “Keeping Motorola on a Roll,” Fortune, April 18, 1994, pp. 67–78; “How
Motorola Lost Its Way,” Business Week, May 4, 1998, pp. 140–148; “Motorola Can’t
Seem to Get Out of Its Own Way,” Business Week, January 1, 2001, p. 72; “Motorola Is
Ringing Investors, But Will They Pick Up?” Wall Street Journal, January 21, 2002, p.
B3; “Nokia: Lesson Learned, Reward Reaped,” The Economist, July 30, 2007, p. 32; and
“Motorola Loses Market Share, Financial Times, August 23, 2007, p. 13.
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Web Example 8-1
To Reduce Costs, Firms Often Look Far Afield
In order to increase productivity and cut costs to better compete, firms often seek creative
insights in industries far afield from their own. Of course, in a time of increased global
competition, firms routinely scrutinize competitors’ practices in their quest for innovative
products and processes. But seeking inspiration only in one’s own industry has
limitations, and so more and more firms are increasingly looking in other industries and
fields to come up with new products and better ways of doing things. For example, when
Southwest Airlines wanted to improve the turnaround of its aircraft at airports, it did not
examine other airlines’ practices but went to the Indianapolis 500 to watch how pit crews
fuel and service race cars in a matter of seconds. The result was that Southwest was able
to cut its turnaround time by 50 percent. Such a drastic increase in productivity could
hardly be accomplished by observing other airlines’ practices. It is, of course, much more
difficult to adapt techniques from other industries, but when it is accomplished, the
potential rewards in terms of increased efficiency can be very great.
The key to finding useful insights in seemingly unrelated fields is to focus on
processes. After all, all firms do basically the same things—hire employees, buy from
suppliers, carry on production processes, sell to customers, and collect payments. For
example, a firm seeking to speed its production process might look at Domino’s Pizza, an
outfit that takes an order, produces the pizza, delivers it, and collects the money—all in
less than 30 minutes. A major gas utility firm discovered ways to greatly speed the
delivery of its fuel to customers by observing how Federal Express delivers packages
overnight. Similarly, a firm delivering gravel learned how to greatly speed deliveries by
having truck drivers plug a card into a machine requesting the quantity of gravel to load
without the need for the driver to get off the truck and waste a great deal of time filling
order forms—just as automatic teller machines work at banks. In 1999, General Motors
adopted the system used by the federal Centers for Disease Control and Prevention
(CDC) to track down diseases and spot outbreaks to the industrial tasks of debugging its
cars; this is expected to eliminate some nine million claims and save it $1.6 billion in
warranty repairs in two years and Motorola is using the biological code DNA to define
circuit patterns on semiconductors. To build a better wind turbine, GE Build a global
team of researchers from Germany, Chine, India, and the United States; to look for new
medicines, Novartis, the Swiss pharmaceutical company, went to a laboratory in
Shanghai specializig in ancient remedies; and the technology behind the Intel’s Centrino,
now a $5 billion business, was born in an R&D lab in Israel.
Source: “To Compete Better, Look Far Afield,” The New York Times, September 18,
1994, Sec. 3, p. 11; “GM Takes Advice from Disease Sleuths to Debug Cars,” The Wall
Street Journal, April 8, 1999, p. B1; “Motorola New Research Efforts Look Far Afield,”
The Wall Street Journal, June 17, 1999, p. B6; and “Te World of Ideas,” Fortune, July
25, 2005, pp. 90–96.
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Web Example 9-1
The Russian Wheat Deal and U.S. Wheat Prices
In July 1982, the then Soviet Union announced that it would purchase 400 million bushels
of winter wheat from the United States. This was approximately one-quarter of the total U.S.
annual production. With the short-run supply curve for winter wheat fairly price inelastic,
the increased demand for American wheat led to a sharp rise in the price of wheat in the
United States—from about $1.60 per bushel at the end of June 1982 to about $2.25 by the
end of September.
The size of the Russian wheat deal caught many farmers by surprise and angered
those who had sold their wheat just before the wheat deal was announced. The increase in
demand for American wheat led to an increase in the price of wheat, exactly as predicted by
our model (see the right panel of Figure 9-8 in the text). Furthermore, since the supply curve
for American (winter) wheat was fairly price inelastic, the price increase was sharp. In the
face of continued difficulties in Russian agriculture and in the expectation of continued
purchases of American wheat by the Soviet Union and high wheat prices in the United
States, American farmers increased their wheat output in 1983 and 1989 (also as predicted
by our model). The same occurred with corn in 1989.
During the 1990s, the demand for U.S. wheat increased as a result of U.S. aid to
Russia to purchase American food after the fall of communism and as a result of the
subsidies that the U.S. government gave for exporting American wheat to counter European
subsidies. By increasing the demand for American wheat, these measures also tended to
keep wheat prices and production in the United States above what they would have been.
Agricultural production and prices, however, depend even more on the vagaries of the
weather.
Source: B. Luttrell, “Grain Export Agreements,” Federal Reserve Bank of St. Louis Review,
August/September 1981; “Signs of Big Soviet Purchase Push Corn Prices Higher,” New
York Times, October 20, 1989, p. D3; “U.S. Offers Russia Aid in Buying Food,” New York
Times, September 15, 1992, p. 6; “U.S. Wheat Subsidies Are Message to Europe,” New
York Times, September 3, 1992, p. D2; “Weathering the Weather Market,” Business Week,
August 21, 1995, p. 31; “Drought in Texas and Oklahoma Stunting Crops and Economies,”
New York Times, August 12, 1998, p. 1; Strong Harvest Set to Restrain Wheat Price Rise,”
Financial Times, January 27, 2000, p. 34; “Wheat Forecast Slashed Again, Financial Times,
October 31, 2007, p. 3.
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Web Example 10-1
Restrictions on Competition in the Pricing of Milk in New York City and the Nation
Retail milk prices in New York State have been kept artificially high by an antiquated law passed
during the Great Depression of the 1930s that required milk dealers to obtain a license to operate in
any local market in the state. The commissioner of agriculture, appointed by the governor, had the
responsibility of granting these licenses, except when they led to “destructive competition in a
market already adequately served.” In practice, however, commissioners did not issue licenses if
these threatened the profits of established local dairies. The result was that retail milk prices in
New York State were about 20 percent higher than in neighboring New Jersey. In 1986, the
commissioner finally allowed a New Jersey dairy firm to sell milk in Staten Island (a borough of
New York City), and immediately the price of milk in the borough declined by 20 percent. The
commissioner, however, under strong pressure from local dairies (which contended that they could
not tolerate more competition because their costs are higher), rejected the application for a license
from the same New Jersey dairy firm to sell milk in two other boroughs of New York City.
These state regulations are in addition to federal regulations that have set minimum prices for
fluid milk since the time of the Great Depression with the intent of stabilizing milk prices, thereby
ensuring reliable supplies across the country. Under federal law, the country was divided into 31
regions, with the U.S. Department of Agriculture setting the minimum price that farmers in each
region could charge for milk each month. Minimum prices were set higher the farther the region is
from Eau Claire, Wisconsin, historically the center of the dairy industry. Then, the 1996 Freedom
to Farm Act instructed the secretary of agriculture to develop a more market-oriented dairy system
by 1999. In July 1997, the Northeast Interstate Dairy Compact (a cartel) was allowed to set a
minimum wholesale price for milk above the federal minimum price in the six Northeastern states.
Five other Atlantic states (New York State, New Jersey, Pennsylvania, Delaware, and Maryland)
also applied to join the Northeast Interstate Dairy Compact and Southern states indicated their
intent to form a dairy cartel of their own.
In spring 2002, however, Congress refused to extend the law allowing the Dairy Compact to
exist but included a new subsidy program in the Farm Bill signed into law. The new Farm Bill
provides farmers a subsidy when the market price of milk falls below the price that the Dairy
Compact would have set. But taxpayers, instead of consumers, now foot the bill and the new
program is administered by the U.S. Department of Agriculture rather than by the Dairy Compact
in the affected States. The dairy industry is but one clear case in which government regulations
(both state and federal) restricted entry and competition and led to higher prices for consumers and
profits for firms in the industry.
Source: “The Price of Monopoly Milk,” The New York Times, February 10, 1986, p. 22; “The Milk Cartel,” The
New York Times, September 1, 1987, p. 22; “The OPEC of Milk,” The Wall Street Journal, June 20, 2001, p.
A18; “Reversing Course, Bush Signs Bill Raising Farm Subsidies,” New York Times, May 14, 2002, p. 16;
“Senate Panel Extends Milk Subsidies Amid Farm Cuts,” Wall Street Journal, October 20, 2007, p. A4; for
updates, see: http://www.cato.org/pub_display.php?pub_id=8479 and http://www.dairycompact.org.
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Web Example 11-1
The Monopolistically Competitive Restaurant Market
The restaurant market in any city has all the characteristics of monopolistic competition.
There are usually thousands of restaurants in any large city, catering to all types of foods,
tastes, incomes, and sectors. Some restaurants are very luxurious and expensive, while
others are simple and inexpensive. Some restaurants provide entertainment, while others
do not. Some are located in the theater district and serve pre-theater dinner and aftertheater supper, while others are located in residential areas of the city and cater to the
family business.
In one block in mid-Manhattan, the author recently counted 19 restaurants: 5
Italian, 4 French, 3 Chinese, and 1 Brazilian, Indian, Japanese, Korean, Mexican,
Pakistani, and Spanish. In a recent issue of New York Magazin,e more than 100
restaurants of all types were advertised, and these are only a very small fraction of the
restaurants located in the city. Entry into the restaurant business is also relatively easy
(witness the hundreds of new restaurants that open each year and the about equal number
that close in any large city during the same year). Since each restaurant offers a
somewhat differentiated product, many advertise their existence, location, and menu,
together with the usual claim (which no one really takes seriously) of superiority over all
other restaurants in the same class.
Source: The New York, January 2008.
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Web Example 12-1
The Objective and Strategy of Firms in the Cigarette Industry
Until the rash of recent legal suits and court rulings on the health damages of cigarette
smoking, the objective of firms in the cigarette industry seemed to be the maximization
of long-run profits or firm value, as postulated by the theory of the firm. Different firms,
however, pursued these goals differently. The doubling of the federal excise tax on each
pack of cigarettes on January 1, 1983, as well as the rise in other state taxes since then,
resulted in a sharp increase in cigarette prices and a reduction in consumption. In order to
lure customers from rivals and maintain profit levels, the weaker three of the nation’s six
major producers introduced generic cigarettes. These contain cheaper tobacco, come in
plain black-and-white packages, are advertised very little, and sell at less than half the
price of name brands.
The other three major producers, instead, followed the more traditional marketing
strategy of brand proliferation. That is, they introduced a large number of new brands to
appeal to every conceivable taste or consumer group and spent hundreds of millions of
dollars on advertising. They resisted the introduction of generic cigarettes because these
cigarettes have very low profit margins. But as sales of generic cigarettes rose, these
other major producers responded with the introduction of discounts—brand-name
cigarettes that cost more than generics but less than the traditional brands. Then on
Friday, April 2, 1993 (which became known as the infamous Marlboro Friday), Philip
Morris took the unusual step of cutting the price of Marlboro cigarettes (one of the
world’s best-known and profitable brands) and its other premium brands by 20 percent
(about 40 cents per pack) in an effort to contain continued loss of market share to generic
cigarettes. RJR Nabisco, Philip Morris’s main competitor, quickly matched the price cut.
At the same time, both groups of cigarette producers greatly expanded sales abroad.
With the antismoking campaign going global, however, and with a Worldwide AntiSmoking Treaty singed in February 2004 severely restricting advertising and marketing
practices, international sales of American cigarettes also slowed down.
In recent years and as a result of the rash of lawsuits on the harmful health effects of
smoking, cigarette companies have been forced to change their strategy to that of
containing potential financial losses from adverse court rulings. Thus, in November 1998,
they agreed to pay $246 billion over 25 years to settle the high-profile national effort on
the part of 46 states to recoup public-health costs linked to smoking. This added 42.5
cents to each pack sold by Big Tobacco and resulted in their loss of market share to the
three Minors (that were not part of the settlement) from 99.6 percent to 91.9 percent. In
2005, the U.S. Justice Department also asked for a $10 billion penalty from tobacco
companies (scaled down from $130 billion recommended by a government witness) to
finance a stop-smoking campaign at the conclusion of a long-run case filed in 1999 that
charged them conspiracy to promote smoking and misleading to public on the dangers of
smoking.
(Continued on the next page)
(Continued from the previous page)
Source: “Big Tobacco’s Toughest Road,” U.S. News & World Report (April 17, 1989), p. 26;
“Philip Morris Cuts Cigarette Prices, Stunning Market,” New York Times, April 3, 1993, p. 1;
“Cigarette Makers and States Draft a $206 Billion Deal,” New York Times, November 14, 1998,
p. 1; “Major Makers of Cigarettes Raise Prices,” Wall Street Journal, August 31, 1999, p. A3;
“Worldwide Anti-Tobacco Treaty Takes Effect,” New York Times, February 28, 2004, p. 8;
“Tobacco Trustbuster,” Forbes, February 28, 2005, pp. 86–89; “The High Cost of Nicotine
Withdrawal,” Newsweek, May 23, 2005, p. 40; and “Limit for Award in Tobacco Case Sets Off
Protests,” New York Times, June 9, 2005, p. 1.
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Web Example 13-1
Transfer Pricing
The U.S. Internal Revenue Service, bolstered by new Auditing powers, is investigating
many American Subsidiaries of foreign firms on the suspicion that they have underpaid
U.S. corporate income taxes by as much as $12 billion. Indirect evidence of this is given
by the fact that the ratio of income tax payments to total receipts of foreign-controlled U.S.
corporations was less than half that of U.S. corporations. Even more incredible is the fact
that of the nearly 37,000 foreign-owned companies filing returns in 1986, more than half
reported no taxable income! In 1991, the IRS adopted an “advance pricing agreement”
with an increasing number of multinational corporations on the range of prices at which to
value the various products that these multinationals import to the United States, so as to
avoid transfer pricing disputes. But such disputes continue.
In 1993, Nissan had to pay $144 million to the U.S. Internal Revenue Service to settle
claims arising from transfer pricing; in 1996, Japan filed claims for nearly $500 million in
back taxes for transfer pricing against more than 50 multinational corporations; in 2000
DailmerChrysler had to pay an extra $46 million in taxes to Japan because of transfer
pricing, and in the same year Nissan also had to pay extra taxes to the United Kingdom for
the same reason. The foreign profits of the six largest U.S. drug companies rose from 38
percent of their overall income in 1994 to more than 65 percent in 2003 even though the
share of overseas sales grew only slightly. As a result, taxes on corporate profits for those
companies fell from the 31 percent rate on domestic profits to the 17.5 percent rate on
foreign profits.
By far the largest transfer pricing case to date was the one which the IRS brought against
the pharmaceutical group GlaxoSmithKline (GSK) in 2006 which was settled by GSK
paying $3.4 billion without going to trial. Still pending is a 2006 case in which the IRS is
seeking to recoup $2.3 billion from Merck for unpaid taxes on profits transferred to
Bermuda. Since 2002, the United States began to aggressively crack down on a new type
of transfer pricing used by U.S. and foreign computer and pharmaceutical companies
arising from their transfer of intellectual property (such as trademarks and patents) to tax
havens to avoid paying taxes on the income generated from those properties.
Source: “I.R.S. Investigating Foreign Companies for Tax Cheating,” New York Times, February 10,
1990, p. 1; “Big Japan Concern Reaches an Accord on Paying U.S. Tax,” New York Times,
November 11, 1992, p. 1; “Why Do Foreign Companies Report Such Low Profits on Their U.S.
Operations?” Wall Street Journal, November 2, 1994, p. A1; “Japan’s Tax Man Leans on Foreign
Firms,” Wall Street Journal, November 25, 1966, p. C21; “DaimlerChrysler Japan Forced to Pay
More Tax,” Financial Times, October 10, 2000, p. 22; “Nissan’s U.K. Arm Hit by Tax Charges,”
Financial Times, November 8, 2000, p. 27; “A New Twist in Tax Avoidance: Firms Send Best
Ideas Abroad,” Wall Street Journal, June 24, 2002, p. A1; “Treasury Cracks Down on Companies
Shifting Profits to Low-Tax Jurisdictions,” Financial Times, August 25, 2005, p. 1; and “How
Merck Saved $1.5 Billion Paying Itself for Drug Patents,” Wall Street Journal, April 28, 2006, p.
A1.
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Web Example 14-1
The Glut of Lawyers and Doctors in the United States
There are more than one million lawyers in the United States in 1981—up from 355,000 in
1971 and spending on legal services increased from $10 billion to more than $100 billion
from 1950 to 1980. Although some increase in the number of lawyers was justified by
population growth, the proliferation of laws and regulations, and the greater propensity on
the part of citizens to bring legal action, 70% of the members of the American Bar
Association believe that the boom has gotten out of hand and that something must be done
to limit their number. As predicted by economic theory, the larger increase in the supply,
relative to the demand, of law services resulted in a reduction in the price of many law
services, such as for uncontested divorces, wills, small personal injury cases, and
nonbusiness bankruptcy cases. (It is primarily in large corporate disputes that costs are
rising sharply and multimillion dollar fees are becoming the rule rather than the exception.)
Competition for business has resulted in attorneys setting up legal clinics, often in
drugstores and shopping malls, to handle simple cases at cut-rate prices. Lawyers’ search for
business has also been blamed by some for the rash of lawsuits in recent years. In their
search for business, lawyers have also increasingly turned to advertising since 1977, when
the U.S. Supreme Court abolished state prohibitions against advertising. Things were not
much changed in 2007!
An oversupply of doctors also seemed to exist in the United States in the 1980s and
1990s when the ratio of doctors to patients nationwide was about 250 per 100,000, well
above the ratio of 150 to 100,000 that many experts consider optimum. The prediction
was that if the number of doctors continued to grow as the past rate, the ratio would have
grown to 290 per 100,000 by the turn of the century, greatly increasing the oversupply.
This led the American Medical Association (AMA) to call for cutbacks of 20 to 25
percent in medical school enrollment (in the face of increasing applications) and limits on
the number of foreign physicians entering the country. The Federal Trade Commission,
however, however, ruled (and its ruling has been upheld by the Supreme Court) that the
AMA, as any other professional group, is subject to the antitrust laws prohibiting
restraints of trade. To be sure, not all medical specialties were equally affected. For
example, a “shortage” of psychiatrists (especially child psychiatrists) was developing, but
a major “surplus” of surgeons, obstetricians, pediatricians, cardiologists, and diagnostic
radiologists was expected. While doctors were not unemployed, some are having trouble
getting enough patients and were recommending more unnecessary treatment. Economic
theory predicts that, under these circumstances, a completely free market would result in
lower (or less rapidly rising) prices for medical services and physicians’ incomes.
The situation seemed to have completely reversed during the present decade. While in
1994 the Journal of the American Medical Association predicted a surplus of 165,000
doctors by 2000, the prediction in 2005 was that because it takes 10 years to train a
doctor, the nation will have a shortage of 85,000 to 200,000 doctors in 2020 unless action
is taken soon. It is not that the number of doctors declined during the past decade (in fact
the number of active physicians in the United States increased from 500,000 in 1985 to
800,000 in 2005) but, instead, that the demand for doctors’ services increased even more.
Sources: “A Glut of Lawyers—Impact on U.S.,” U.S. News & World Report, December 19, 1983,
pp. 59-61; “The Legal Profession,” The Economist, July 18, 1992, pp. 3-18; “A.M.A. Board Studies
Ways to Curb Supply of Physicians,’’ New York Times, June 16, 1986, p. 1; “Rising Supply of
Doctors May Be Bad for Health Costs,” Wall Street Journal, May 8, 1991, p. B1; “Medical Schools
Are Urged to Cut Admissions,” New York Times, November 17, 1995 p. D2; “Hard Case: Job
Market Wanes for U.S. Lawyers,” Wall Street Journal, September 24, 2007, p. A1;
http://www.usatoday.com/news/health/2005–03–02-doctor-shortage_x.htm; and
http://www.larouchepub.com/other/2007/3401dr_nrs_shortage.html
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Web Example 15-1
Change in the Occupational Distribution of the U.S. Labor Force: 1990–1999
The following table shows the very large change in the male and female occupational
distribution of the U.S. labor force in the century between 1900 and 1999. In 1900, most
males and a very large proportion of the females labor force were in agriculture. By 1999,
agriculture accounted for the smallest proportion of the males and female labor force
among the six occupational categories specified in the table. There was a sharp increase
in the percentage of professional males and especially females in the labor force. For
females, there was a sharp switch away from service, manufacturing and agriculture in
favor of professional, clerical and sales over the century. For males, the switch was
primarily from agriculture to professional, sales and service.
_ Change in the Occupational Distribution of the U.S. Labor Force Between 1900 and
1999
1900__________
1999__________
Male Female Difference
Male Female Difference
Professional
10.2%
9.6%
0.6
31.5% 35.9%
-4.4
Clerical
2.8
4.0
-1.2
5.5
23.4
-17.9
Sales
4.6
4.3
0.3
11.3
13.0
-1.7
Manufacturing
37.6
27.7
9.9
37.9
9.2
28.7
Service
3.1
35.5
-32.4
9.9
17.4
-7.5
Agricultural
41.7
19.0
22.7
3.8
1.1
2.7
________________________________________________________________________
_______________________________________________________________________
Source: “From Mill Town to Board Room: The Rise of Women’s Paid Labor,” Journal
of Economic Perspectives, Fall 2000, pp. 101–122.
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Web Example 16-1
Rates of Return on U.S. and Foreign Share Price
The following table shows the average rate of return in dollar terms on share price indices in the
United States and in a selected number of the 83 countries for which this data were collected
from October 9, 2002 (when the American Stock market hit bottom) to October 2007. The
respectable average return in the U.S. S&P 500 of 15% shown in the table ranked only 79th
among the 83 countries. The highest return was in Peru (88%); Brazil ranked 4th with an average
return of 74%, while the lowest return among the 83 countries was in Costa Rica (8%). To be
noted, however, is that since the returns were measured in dollars, the returns in local currency
were much less for those countries whose currency appreciated with respect to the dollar over the
past five years. For example, of the 34 percent returns in Germany, 23 percent (this is how much
the euro appreciated with respect to the dollar from October 2002 to October 2007) was due to
the appreciation of the euro with respect to the dollar and only 11 percent was the return in terms
of the local currency (the euro).
Rates of Return on Share Price Indices in U.S. Dollars in a
Selected Group of Countries, October 2002 to October 2007
_____________________________________________________________
Country
Average
Country
Average
___________________Return______________________________Return_
Peru (1)
88%
Canada (47)
32
Brazil (4)
74
Spain (49)
32
Turkey (9)
55
Australia (51)
30
Poland (11)
51
Singapore (59)
28
India (12)
50
Thailand (60)
27
Argentina (18)
47
Hong Kong (62)
26
Russia (21)
44
France (63)
26
Mexico (31)
39
Italy (60)
23
South Africa (33)
38
Britain (74)
20
South Korea (37)
35
Japan (78)
16
Germany (39)
34
United States (79)
15
China (46)
33
Costa Rica (83)
8
_____________________________________________________________
Source: “Strong Gains in the U.S., Except by Comparison,” Wall Street
Journal, October 13, 2007, p. C3.
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Web Example 17-1
Exchange in POW Camps
Prisoner-of-war (POW) camps during World War II provide an example of pure exchange.
In these camps, little or no production took place, but prisoners received rations of many
products from the detaining power, from the Red Cross, and from private
parcels. The
products included canned milk, sugar, butter, chocolates, cookies, cigarettes,
razor
blades, and writing paper. Soon after receiving rations, prisoners
voluntarily began to
exchange the received products among themselves, in order to end up with a bundle of
goods that better fit their different tastes. Individuals who did not smoke exchanged some of
their ration of cigarettes for cookies, chocolates, or other products with other prisoners.
People who did not care much for chocolate exchanged much of it for other products, and so
on. Since exchange was voluntary, the strong presumption is that all parties to the exchange
benefited. Equilibrium would be reached and exchange would come to an end when the
marginal rate of substitution between all pairs of products was more or less equal for all
prisoners consuming each pair of products.
Source: R.A. Radford, “The Economic Organization of a POW Camp,” Economica,
November 1945, pp. 189–201.
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Web Example 18-1
The Fable of the Apples and the Bees
For decades, economists have used the tale of the apples and the bees as a classic example of
externalities. That is, the owner of beehives receives an external benefit, in the form of free
nectar, which his or her bees extract from the neighbor’s apple blossoms to produce honey.
At the same time, the apple grower receives an external benefit in the form of free
pollinating services for his or her apple blossoms from the neighbor’s bees, which increase
crops. Both the apple grower and the owner of the beehives receive external (i.e., unpaid)
benefits from the other.
At least so it was thought, until Steven Cheung took the time to investigate the case
in the state of Washington. He found that apple growers and bee keepers were quite aware
of the external benefits that each conferred on the others and routinely attempted to
internalize (i.e., extract a payment for) the benefits they provided. This was done by
contracts for the placement of beehives on the farms. These contracts specified the number
of beehives, the average number of bees in each, the dispersion of the hives throughout the
farm, the time period, and even bee protection against insecticides. When honey production
was large, bee keepers paid farmers (i.e., signed apiary leases) for the right to place hives on
the farm. On the other hand, when honey production was very little, farmers paid bee
keepers to have hives placed on their farm for pollinating purposes (i.e., signed pollinating
contracts). Indeed in many localities one can find the entry “pollinating services” in the
yellow pages. The amount of actual payment in one direction or the other also depends on
the size of the net external benefits received by one of the two parties. By doing so,
externalities were, for the most part, internalized.
Note that by inventing the fable of the apples and the bees in order to provide an
example of externalities, it seems that economists have themselves created an external cost
by theorizing without adequate empirical investigation. As pointed out in section 1.6 of the
text, theoretical speculation (in the form of the hypotheses) and empirical verification should
go hand in hand. In recent years, honeybees seems to be vanishing and scientists are racing
to find the reasons and reverse the process.
Source: Steven N.S. Cheung, “The Fable of the Bees: An Empirical Investigation,” Journal
of Law and Economics, April 1973, pp. 11–33; “America’s Beekeepers: Hives for Hire,”
National Geographic, May 1993, pp. 73–93; “Honeybees, Gone with the Wind Leave Crops
and Keepers in Peril,” New York Times, February 2, 2007, p. 1; and “Bees Vanish; Scientists
Race for Reasons,” New York Times, September 24, 2007, p. F1.
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Web Example 19-1
Information and the Limits to Workers Privacy
You find out that a co-worker driving an 18-wheeler for the company is having a new bout
with alcoholism. Do you tell the boss? The question was posed to 4,000 human resource
managers at a recent conference. The audience voted nearly five-to-one in favor of telling
the company. One participant expressed the sentiments of the vast majority of those present
by saying “no way would I let this driver on the road, to kill people.” The result was
different on the next question. Do you tell Jack’s girlfriend that Jack tested positive on
H.I.V.? The vast majority of the audience answered no to this question. Why? The reason
given was that while both the driver and the person infected with H.I.V. could cause another
person’s death, the first could do so while at work and using a company’s vehicle, whereas
the other could do so privately and after work.
While in these two situations, there was agreement among the vast majority of the
participants as to what to do, there is in general a great deal of confusion about the rights to
privacy of employees and the actions that a company might want to take to gather
information about employees behavior and the action to take when potentially harmful onthe-job behavior is uncovered. Confusion is not likely to be dispelled by referring to the
188-page book on worker privacy from the Bureau of National Affairs, a nonprofit
organization that monitors government rulings on this problem. A Federal rule on alcohol
abuse reported in this volume states: “Any disclosure made . . . whether with or without the
patient consent, shall be limited to information necessary in the light of the need or purpose
for the disclosure.” Not much help!
One way to overcome some of this confusion is to have clear company behavioral
guidelines. For example, a worker at IBM dated a co-worker who then went to work for a
competitor. The worker was told to break the relationship and when she refused she was
fired. She sued IBM and won. The reason was not that IBM or any other company has no
right to regulate such relationships, but because IBM guidelines did not specifically forbid
such relationships. In general, when misconduct significantly affects work performance, and
the company has clear guidelines, the company has the right to fire an employee who
disregards the guidelines if the misconduct continues after the employees has been warned.
However, overdrinking on weekends that does not affect the employee’s performance on
Monday should not be punishable, even if such behavior increases long-run health insurance
costs.
Source: “The New Ethics Enforcer,” Business Week, February 13, 2006, pp. 76–77; “Ethics:
This Time Is Personal,” Financial Times, March 24, 2005, p. 7; “The Limits to Worker
Privacy,” New York Times, December 20, 1990, p. F13; “Charting a Course to Ethical
Profits,” New York Times, February 8, 1998, Section 3, p.1.
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