CH-1-3 Economics and Life – Macroeconomics : Book Guide

This Document Contains Chapters 1 to 3 CHAPTER 1 ECONOMICS AND LIFE Chapter Overview Economists approach problems differently from many other people. A basic principle of human behavior underlies economics—the idea that people typically make choices to achieve their goals in the most effective way possible, subject to the constraints they face. In this chapter we have introduced the basic concepts economists use, as well as four questions they ask to break down problems. Throughout this book, you will see these concepts and questions over and over again: 1. Scarcity: What are the wants and constraints of those involved? 2. Opportunity cost: What are the trade-offs? 3. Incentives: How will others respond? 4. Efficiency: Why isn’t someone already doing it? In later chapters, as we progress to more complicated problems, try using these four questions to break down problems into manageable pieces. Then you can tackle those smaller pieces using the four fundamental concepts presented in this chapter. Learning Objectives LO 1.1: Explain the economic concept of scarcity. LO 1.2: Explain the economic concepts of opportunity cost and marginal decision making. LO 1.3: Explain the economic concept of incentives. LO 1.4: Explain the economic concept of efficiency. LO 1.5: Distinguish between correlation and causation. LO 1.6: List the characteristics of a good economic model. LO 1.7: Distinguish between positive and normative analysis. Chapter Outline OPENING STORY: MAKING AN IMPACT WITH SMALL LOANS The Basic Insights of Economics Scarcity (LO 1.1) Opportunity Cost and Marginal Decision Making (LO 1.2) BOX FEATURE: WHAT DO YOU THINK? – THE OPPORTUNITY COST OF A LIFE Incentives (LO 1.3) Efficiency (LO 1.4) An Economist’s Problem-Solving Toolbox Correlation and Causation (LO 1.5) BOX FEATURE: FROM ANOTHER ANGLE – DOES ICE CREAM CAUSE POLIO? Models (LO 1.6) BOX FEATURE: REAL LIFE – TESTING MODELS AGAINST HISTORY Positive and Normative Analysis (LO 1.7) BOX FEATURE: WHAT DO YOU THINK? – THE COST OF COLLEGE CASH Beyond the Lecture Class Discussion: Scarcity (LO 1.1) Have students review this recent TED talk by Peter Diamandis. Peter highlights the impact of human ingenuity on scarcity and argues that we should be optimistic about the use of technology to address problems in the future. This is a great springboard for discussion. 1. Do students think that technology will continue to improve living standards and mitigate the problems associated with scarcity? 2. Despite the fact that technology advancements have greatly improved quality of life and consumption for most people, will we ever eliminate scarcity? Writing Assignment: Opportunity Cost and Marginal Decision Making (LO 1.2) Have students review this article by Russell Roberts on opportunity cost. It highlights some basic examples that are familiar to students. Require students to write a brief essay on the opportunity costs associated with decisions in their lives, decisions that firm’s make, or government decisions. This can be used as a catalyst for class discussion as well. Class Discussion: Opportunity Cost and Marginal Decision Making (LO 1.2) Your class that you teach is most likely 50 or 75 minutes in length. Poll the students (perhaps informally, or using software such as Poll Anywhere or clickers) and ask them what they would be doing during this hour if they were not in class. Some possible answers may include sleeping (especially for an early AM class), working out, studying for another course, watching TV, eating, or many others. This is a great introduction to opportunity cost – the cost of attending class is giving up the next best alternative of your time. Questions to ask include: 1. Is your opportunity cost the same as other students’ opportunity cost? 2. Does the fact that you chose to attend class today mean that sitting in this economics lecture is the best use of your time during this hour? Class Discussion: Incentives (LO 1.3) In order to highlight the importance of incentives, consider discussing Chapter 3 of Freakonomics by Steven Levitt and Stephen Dubner with your students. The chapter provides insight into the career of an individual who is involved in the illegal drug market. You could also ask students to review this Los Angeles Times commentary on the chapter, also written by Levitt and Dubner. 1. Ask students to consider why an individual would be willing to endure the risks associated with the illegal drug market given the relatively low pay and poor working conditions that many workers endure. Students really enjoy this interesting discussion. 2. How does this market compare to other markets? There are surprising similarities and differences between legal markets and the black market. Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. What is the result of scarcity of goods and services? [LO 1.1] A. People can have all the goods they desire at any price B. Only government can provide enough goods for the people C. People may experience poverty D. Any economic system must have a method to allocate goods and services Feedback: With scarcity, we don’t have enough goods to freely be given to everyone to satisfy all wants. Thus, a method to allocate goods must be used. This could include prices, or other methods. Note that poverty isn’t a direct result of scarcity – scarcity affects all people, both rich and poor. 2. “Children eat more ice cream in the summer. Children are more likely to drown in the summer. We can conclude that ice cream consumption causes drowning.” The previous statement is an example of____________. [LO 1.5] A. Normative economic statements B. Negative incentives resulting in undesirable outcomes C. Confusing correlation with causation D. Opportunity cost creating tradeoffs 3. Which of the following do you think is most likely necessary to create a good economic model? [LO 1.6] A. Identical to the real world and no simplifications B. Changing assumptions until all problems are eliminated in the model C. Finding a lot of experts who agree with my opinions before building the model D. A set of well-defined variables with data that we wish to study Feedback: Remember that models by definition are a simplification of reality. We can’t have a model that is identical to the real world economy. It would require billions of variables, trillions of data points, and multiple supercomputers to analyze the data! 4. Which of the following is an incentive your instructor could provide to get more students to attend class? [LO 1.3] A. Giving extra credit to students who attend more than 90% of classes B. Handing out candy to students who attend C. Failing students who miss a class without a University-approved excuse D. All of the above Feedback: Remember that incentives can be positive or negative. We don’t want to ask which incentives we would personally agree with. We just want to ask if the incentive would change behavior. 5. A rational person should only do an activity as long as [LO 1.2] A. The marginal benefits are greater than the marginal costs B. There are no costs to the activity C. It can earn them money D. The opportunity costs of doing the activity are low Feedback: People do activities even if opportunity costs are high. One example is going to college and not working for four years during your time as a student! Solutions to End-of-Chapter Questions and Problems Review Questions 1. Suppose you are shopping for new clothes to wear to job interviews, but you’re on a tight budget. In this situation, what are your wants and constraints? What does it mean to behave rationally in the face of scarcity? [LO 1.1] Answer: If you are deciding what to buy for a job interview, your want is to buy clothing that looks clean and professional, so you can present the best possible impression to potential employers. Your constraint is the amount of money you can spend on this clothing. A person behaving rationally would buy the nicest clothes they could afford. 2. You are a student with a demanding schedule of classes. You also work part time and your supervisor allows you to determine your schedule. In this situation, what is your scarce resource? How do you decide how many hours to work? [LO 1.1] Answer: Your scarce resource is time. You need both time to study and time to work. Presumably, you want to do well in school and also make money. You will try to balance your schedule so that you work as much as possible while still having enough time to study and do well in school. 3. Think about the definition of scarcity that you learned in this chapter. Name three ways that you confront scarcity in your own life. [LO 1.1] Answer: People face scarcity in many aspects of their lives. Some people love to travel and explore new places, so they face scarcity in both time and money that keeps them from traveling as often as they would like. Others face scarcity in their professional life, in that there are often many worthwhile projects to address, but the available resources are limited in terms of employees, time, and budget. 4. When shopping for your interview clothes, what are some trade-offs you face? What is the opportunity cost of buying new clothes? What are the benefits? How do you balance the two? [LO 1.2] Answer: The money you spend on clothes for a job interview could be spent on other things instead, so it is one opportunity cost. Another opportunity cost is the time you spend shopping, which could be spent preparing for your interview or playing Frisbee. The benefits include looking put-together during the interview, which provides a boost to your job prospects. You balance the costs and benefits by accepting costs that are less than (or no greater than) the benefits they provide. 5. You have an 8:30 class this morning but you are feeling extremely tired. How do you decide whether to get some extra sleep or go to class? [LO 1.2] Answer: If you are behaving rationally, you decide by comparing the trade-offs. The opportunity cost of going to class is missing out on some extra sleep. Depending on what else in on your schedule that day (perhaps an important interview), it may make sense to choose extra sleep over class. The opportunity cost of extra sleep is that you will miss the lecture. If your grade will suffer significantly by your absence, you may want to grab some coffee and go to class! 6. It’s Friday night. You already have a ticket to a concert, which cost you $30. A friend invites you to go out for a game of paintball instead. Admission would cost you $25, and you think you’d get $25 worth of enjoyment out of it. Your concert ticket is nonrefundable. What is your opportunity cost (in dollars) of playing paintball? [LO 1.2] Answer: The opportunity cost of going to play paintball is whatever amount of enjoyment (in dollars) you would get out of going to the concert. The thirty dollars you paid for the concert ticket is not relevant to the decision, as it is a sunk cost and is nonrefundable regardless of what you do. 7. Suppose you have two job offers and are considering the trade-offs between them. Job A pays $45,000 per year and includes health insurance and two weeks of paid vacation. Job B pays $30,000 per year; it includes four weeks of paid vacation but no health insurance. [LO 1.2] a. List the benefits of Job A and the benefits of Job B. b. List the opportunity cost of Job A and the opportunity cost of Job B. Answer: a. The benefits of Job A are the extra pay and health insurance. For Job B, the benefit is two extra weeks of vacation. b. The opportunity cost of Job A is losing out on the extra two weeks of vacation that comes with Job B. For Job B, the opportunity costs are the extra $15,000 in salary along with the health insurance. 8. Your former neighbor gave you his lawnmower when he moved. You are thinking of using this gift to mow lawns in your neighborhood this summer for extra cash. As you think about what to charge your neighbors and whether this idea is worth your effort, what opportunity costs do you need to consider? [LO 1.2] Answer: You need to consider the opportunity cost of your time. Your lawn mowing business would need to cover the opportunity cost of what you could earn in another summer job. You also need to consider the cost of gasoline for the mower and the value of the lawn mower itself. Just because it was a gift does not mean that it has no opportunity cost. The opportunity cost of using the lawnmower for your business is its sale value, if you decide to sell the gift rather than use it yourself. Your lawn mowing business needs to cover all of these costs (the value of your time in another job, gasoline, and the sale value of the lawnmower) in order for it to be a worthwhile endeavor. 9. Think of a few examples of incentives in your daily life. How do you respond to those incentives? [LO 1.3] Answer: An incentive is something that causes people to behave in a certain way by changing the trade-offs they face. No parking signs encourage people not to park in certain places and speed limit signs encourage people not to drive too fast. The consequence in either case is the risk of getting a ticket. The ability to devote a certain percentage of income to a 401(k) retirement account each month before paying taxes encourages people to save for retirement. 10. You supervise a team of salespeople. Your employees already receive a company discount. Suggest a positive incentive and a negative incentive you could use to improve their productivity. [LO 1.3] Answer: For a positive incentive, you could offer a reward such as a bonus, a gift certificate, or an extra discount on company merchandise to the most productive employee of the month. For a negative incentive, you could announce that employees who fail to meet targets will lose their company discount. 11. Your boss decides to pair workers in teams and offer bonuses to the most productive team. Why might your boss offer team bonuses instead of individual bonuses? [LO 1.3] Answer: Your boss is creating a reward system for a project that requires group effort. Even if you are not motivated to compete for an individual bonus, you are likely to feel responsibility to your teammate and make a greater effort to be productive. Your teammate can encourage, pressure, and/or help you to achieve greater productivity. 12. Think of a public policy—a local or national law, tax, or public service—that offers an incentive for a particular behavior. Explain what the incentive is, who is offering it, and what they are trying encourage or discourage. Does the incentive work? [LO 1.3] Answer: The U.S. government places a subsidy on growing corn. This provides an incentive for farmers to plant corn on more of their land instead of alternative crops. The government is trying to encourage the production of domestic corn so that the United States can produce corn-based ethanol more cheaply. 13. Why do individuals or firms usually provide the goods and services people want? [LO 1.4] Answer: If firms didn’t produce goods that people want, no one would buy their goods. These firms would lose money and go out of business, and would be replaced by firms that did produce goods that customers want. 14. You may have seen TV advertisements for products or programs that claim to teach a surefire way to make millions on the stock market. Apply the Why isn’t someone already doing it? test to this situation. Do you believe the ads? Why or why not? [LO 1.4] Answer: Guessing which stocks are going to perform well and which are going to tank is a hard if not impossible task, which makes it very hard to make millions in the stock market. You should not believe the ads for that reason. (If there really was a surefire way to make millions, you can bet everyone would already be doing it!) 15. Describe an innovation in technology, business, or culture that had a major economic impact in your lifetime. [LO 1.4] Answer: The Internet has completely changed the way people do business. While writing this textbook, we have collaborated with people all over the country, sharing documents online that we once would have had to send through the mail. 16. Why do people confuse correlation with causation? [LO 1.5] Answer: Correlation means that two events occur together. Since the two often occur together, people often believe that one causes the other, but this is not always true. People once thought that ice cream caused polio, for example. The real relationship was that people ate more ice cream in the summer, and this also happened to be the time of year that the polio virus spread more rapidly. 17. Name two things that are positively correlated and two things that are negatively correlated. [LO 1.5] Answer: Events that are positively correlated tend to occur together, or move in the same direction. For example, more people tend to carry an umbrella when the risk of rain is high. When one event increases at the same time a related event decreases, then the two events are negatively correlated. According to auto insurers, good grades and the risk of getting in a car accident are negatively correlated. (People with higher grades tend to be safer drivers.) 18. Why is it important for a good economic model to predict cause and effect? [LO 1.6] Answer: A good model must predict cause and effect so that it can explain something about what we have observed and can help us anticipate what will happen in future observations. 19. Why is it important for a good economic model to make clear assumptions? [LO 1.6] Answer: A good model must make clear assumptions so we know when the model will do a good job at explaining or predicting our observations and when it will not. 20. Describe an economic model you know. What does the model predict about cause and effect? [LO 1.6] Answer: As mentioned in this chapter, the model of demand that you will explore in Chapter 3 predicts that a rise in price will cause a decrease in the quantity of a good consumers want to buy and a decrease in price will cause an increase in the quantity of a good consumers want to buy. Think about your own willingness to purchase goods. For most goods, you want to purchase more when the price falls and less when the price goes up. The model does a good job at predicting cause and effect. 21. Describe an economic model you know. What assumptions does the model make? Are the assumptions reasonable? [LO 1.6] are reasonable assumptions. For most goods, consumers are aware of their preferences and available alternatives. And consumers can usually be relied upon to act rationally enough to spend their resources on the best bundle of goods they can afford. 22. What is the difference between disagreeing about a positive statement and disagreeing about a normative statement? [LO 1.7] Answer: A positive statement is something that is supposed by fact, whereas a normative statement is a value judgment. So disagreeing with a normative statement means you disagree with someone’s opinion. Disagreeing with a positive statement means disputing the truth of fact. 23. Would a good economic model be more likely to address a positive statement or a normative statement? Why? [LO 1.7] Answer: A good model predicts cause and effect and can be tested with evidence. Thus, positive statements are more likely to be addressed by a good model. 24. Write a positive statement and a normative statement about your favorite hobby. [LO 1.7] Answer: Positive statements are based on fact: For example, "Cultures around the world use food to convey social values." Normative statements are based on opinion: For example, "Food is the best way to understand the social values of a culture." Problems and Applications 1. Think about how and why goods and resources are scarce. Goods and resources can be scarce for reasons that are inherent to their nature at all times, that are temporary or seasonal, or that are artificially created. Separate the goods listed below into two groups; indicate which (if any) are artificially scarce (AS) and which (if any) are inherently scarce (IS). [LO 1.1] a. air of any quality b. land c. patented goods d. original Picasso paintings Answer: Goods and resources can be inherently scarce at all times if there is a limited or finite supply of the resource, or artificially scarce when access to the resource is restricted. a. Not scarce. Air (of any quality) is abundant and need not be rationed through prices or some other allocation mechanism b. Inherently scarce. Land is finite in supply; land is available for development, but no new land can be created. c. Artificially scarce. Patented goods are scarce by law; only the patent holder may supply these goods d. Inherently scarce. Original Picasso paintings are finite; no new Picasso’s can be created beyond those that currently exist 2. You are looking for a new apartment in Manhattan. Your income is $4,000 per month, and you know that you should not spend more than 25 percent of your income on rent. You have come across the listings for one-bedroom apartments shown in Table 1P-1. You are indifferent about location, and transportation costs are the same to each neighborhood. [LO 1.1] a. Which apartments fall within your budget? (Check all that apply.) b. Suppose that you adhere to the 25 percent guideline but also receive a $1,000 cost-of-living supplement because you are living and working in Manhattan. Which apartments fall within your budget now? Answer: a. Delancey. Your income and income guidelines represent a constraint on the choices available. Under these guidelines, 25 percent of your monthly income is $1,000. So the only apartment you can afford within your budget is Delancey, at $950. All others are unattainable to you. b. Chelsea and Delancey. The $1,000 monthly cost-of-living supplement expands your set of living options. Your income is now effectively $5,000 per month, so you can afford any apartment that costs $1,250 or less (25% of $5,000). These choices now include Chelsea ($1,200) and Delancey ($950). 3. Suppose the price of a sweater is $15. Julia’s benefit from purchasing each additional sweater is given in the Table 1P-2. Julia gets the most benefit from the first sweater and less benefit from each additional sweater. If Julia is behaving rationally, how many sweaters will she purchase? [LO 1.2] Answer: Julia will purchase all of the sweaters for which the marginal benefit is greater than the marginal cost. If the price of a sweater is $15, this is the marginal cost, as each additional sweater will cost $15. For the first four sweaters, the marginal benefit exceeds the marginal cost, so Julia will purchase four sweaters. For the fifth sweater, the marginal cost of $15 exceeds the marginal benefit. Marginal Benefit Marginal Cost 1st sweater $50 $15 2nd sweater $35 $15 3rd sweater $30 $15 4th sweater $23 $15 5th sweater $12 $15 6th sweater $8 $15 4. Sweaters sell for $15 at the crafts fair. Allie knits sweaters; her marginal costs are given in the Table 1P-3. Allie’s costs increase with each additional sweater. If Allie is behaving rationally, how many sweaters will she sell? [LO 1.2] Answer: Allie will sell all of the sweaters for which the marginal benefit is greater than the marginal cost. If the price of a sweater is $15, this is the marginal benefit, as Allie will receive $15 for each additional sweater she sells. For the first 3 sweaters, the marginal benefit exceeds the marginal cost, so Allie will sell 3 sweaters. Marginal Cost 1st sweater $5 2nd sweater $8 3rd sweater $12 4th sweater $18 5th sweater $25 6th sweater $32 5. Last year, you estimated you would earn $5 million in sales revenues from developing a new product. So far, you have spent $3 million developing the product, but it is not yet complete. Meanwhile, this year you have new sales projections that show expected revenues from the new product will actually be only $4 million. How much should you be willing to spend to complete the product development? [LO 1.2] a. $0. b. Up to $1 million. c. Up to $4 million. d. Whatever it takes. Answer: You should spend up to $4 million. The $3 million you have spent already is a sunk cost and cannot be recovered. Therefore, the $3 million you have spent is irrelevant to the decision of how much to spend going forward. This year, the relevant decision is: How much are you willing to spend to have $4 million in revenue? If you had known that product development may cost you more than you will gain in revenues, you should not have started this project. But at this point, by thinking on the margin, you can see that you should be willing to move forward as long as the costs of going forward are not greater than the benefits of going forward ($4 million). 6. Consider the following examples. For each one, say whether the incentive is positive or negative. [LO 1.3] a. Bosses who offer time-and-a-half for working on national holidays. b. Mandatory minimum sentencing for drug offenses. c. Fines for littering. d. Parents who offer their children extra allowance money for good grades. Answer: a. Positive. b. Negative. c. Negative. d. Positive. 7. Consider the following events that change prices as described in Table 1P-4. For each one, say whether the opportunity cost of consuming the affected good increases or decreases. [LO 1.3] Answer: a. Decreases. e. Increases. f. Increases. g. Decreases. 8. Your best friend has an idea for a drive-through bar. Indicate the best explanation for why others have not taken advantage of her idea: true innovation, market failure, government intervention, or unprofitablity. [LO 1.4] Answer: Government intervention. In most places, drive-thru bars are (wisely) illegal. 9. Your best friend has an idea for a long-distance car service to drive people across the country. Indicate the best explanation for why others have not taken advantage of her idea: true innova-tion, market failure, intervention, or unprofitablity. [LO 1.4] Answer: Unprofitable. There are alternatives for customers that can be cheaper than car service. For example, buses can offer cheaper prices than a car service could. While a car is less costly to operate than a bus, a bus can more than make up the difference in operation cost by accommodating many more passengers. 10. Determine whether each of the following questionable statements is best explained by coincidence, an omitted variable, or reverse causation. [LO 1.5] a. In cities that have more police, crime rates are higher. b. Many retired people live in states where everyone uses air conditioning during the summer. c. More people come down with the flu during the Winter Olympics than during the Summer Olympics. d. For the last five years, Punxsutawney Phil has seen his shadow on Groundhog Day, and spring has come late. Answer: a. Reverse causation: Cities with higher crime rates will tend to have larger police departments. b. Omitted variable: Having a large number of retired people live in a state does not cause everyone to use their air conditioner. Retired people tend to move to warmer states and living in a warm-weather state causes everyone to use air conditioning in the summer. c. Correlation without causation: The Winter Olympics do not cause the flu. The flu season falls during Winter months, which increases the incidence of flu cases at the Winter Olympics vs. the Summer. d. Coincidence: There is no plausible cause-and-effect relationship here. 11. For each of the pairs below, determine whether they are positively correlated, negatively correlated, or uncorrelated. [LO 1.5] a. Time spent studying and test scores. b. Vaccination and illness. c. Soft drink preference and music preference. d. Income and education. Answer: Two items are positively correlated if both variables increase at the same time, or if both variables decrease at the same time. Two items are negatively correlated if one is increasing while the other is decreasing, or vice versa. a. Positively correlated. More time spent studying tends to lead to higher test scores. b. Negatively correlated. More vaccinations result in less illness. c. Uncorrelated. These preferences are not related in any predictable way. d. Positively correlated. People who earn higher income tend to have higher levels of education. 12. Each statement below is part of an economic model. Indicate whether the statement is a prediction of cause and effect or an assumption. [LO 1.6] a. People behave rationally. b. If the price of a good falls, people will consume more of that good. c. Mass starvation will occur as population outgrows the food supply. d. Firms want to maximize profits. Answer: a. Assumption. This is an assumption about how people behave. b. Prediction of cause and effect. This is a prediction of cause and effect because the decline in the price of the good will tend to cause people to consume more of the good, all else the same. One event leads to another. c. Prediction of cause and effect. This is a prediction of cause and effect because if population growth results in the demand for food exceeding the available supply of food, then mass starvation may occur. One event leads to another. d. Assumption. This is an assumption about how firms behave. 13. From the list below, select the characteristics that describe a good economic model. [LO 1.6] a. Includes every detail of a given situation. b. Predicts that A causes B. c. Makes approximately accurate assumptions. d. Fits the real world perfectly. e. Predicts things that are usually true. Answer: A good model should predict cause and effect (b), describe the world accurately (c), and state its assumptions clearly (e). Economists test their models by observing what happens in the world and collecting data that can be used to support or reject their models. 14. Determine whether each of the following statements is positive or normative. (Remember that a positive statement isn’t necessarily correct; it just makes a factual claim rather than a moral judgment.) [LO 1.7] a. People who pay their bills on time are less likely than others to get into debt. b. Hard work is a virtue. c. Everyone should pay his or her bills on time. d. China has a bigger population than any other country in the world. e. China’s One-Child Policy (which limits families to one child each) helped to spur the country’s rapid economic growth. f. Lower taxes are good for the country. Answer: A statement that makes a factual claim about how the world actually works is called a positive statement. A statement that makes a claim about how the world should be is called a normative statement. Economics is a field in which people frequently confuse positive statements with normative statements. However, you do not have to adopt a particular moral or political point of view to use economic concepts and models. a. Positive. b. Normative. c. Normative. d. Positive. e. Positive. f. Normative. 15. You just received your midterm exam results and your professor wrote the following note: “You received a 70 on this exam, the average score. If you want to improve your grade, you should study more.” Evaluate your professor’s note. [LO 1.7] a. Is the first sentence positive or normative? b. Is the second sentence positive or normative? Answer: A statement that makes a factual claim about how the world actually works is called a positive statement. A statement that makes a claim about how the world should be is called a normative statement. Economics is a field in which people frequently confuse positive statements with normative statements. However, you do not have to adopt a particular moral or political point of view to use economic concepts and models. a. Positive. b. Normative. CHAPTER 2 SPECIALIZATION AND EXCHANGE Chapter Overview Specialization and trade can make everyone better off. It is not surprising, then, that in an economy driven by individuals seeking to make a profit or improve their communities, people specialize so as to exploit their comparative advantages. That principle is as true for countries, like the United States and Bangladesh, as it is for individuals picking their careers. No government intervention is required to coordinate production. The great economic thinker Adam Smith suggested the term invisible hand to describe this coordinating mechanism: It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their [self-interest]. . . . he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. The functioning of the invisible hand depends on a lot of other assumptions, such as free competition and full information. Later in the book we will discuss these assumptions, and when they work and when they do not. Most people take for granted the prevalence of specialization and trade in their everyday lives. Few stop to think about the benefits and where they come from. In this chapter we tried to dig down to the bottom of the assumptions people make and expose the logic behind the gains from trade. As we proceed—especially when we return to topics like international trade and government intervention in the markets—try to remember the underlying incentive that drives people to interact with one another in economic exchanges. Learning Objectives LO 2.1: Construct a production possibilities graph and describe what causes shifts in production possibilities curves. LO 2.2: Define absolute and comparative advantage. LO 2.3: Explain why people specialize. LO 2.4: Explain how the gains from trade follow from comparative advantage. Chapter Outline OPENING STORY: THE ORIGINS OF A T-SHIRT Production Possibilities (LO 2.1) Drawing the Production Possibilities Frontier Choosing Among Production Possibilities Shifting the Production Possibilities Frontier Absolute and Comparative Advantage Absolute Advantage (LO 2.2) Comparative Advantage BOX FEATURE: FROM ANOTHER ANGLE – BABE RUTH, STAR PITCHER Why Trade? Specialization (LO 2.3) BOX FEATURE: REAL LIFE – SPECIALIZATION SAUCE Gains from Trade (LO 2.4) BOX FEATURE: WHAT DO YOU THINK? – IS SELF-SUFFICIENCY A VIRTUE? Comparative Advantage over Time BOX FEATURE: REAL LIFE – COMPARATIVE ADVANTAGE: THE GOOD, THE BAD, AND THE UGLY Beyond the Lecture Class Discussion: Production Possibilities (LO 2.1) In order to highlight the concept of the production possibilities curve, have students consider the production possibilities curve for a student deciding how to study for two exams given a fixed timeframe. This helps to highlight the concept of tradeoffs for students, as you can ask them to consider the tradeoff between grades on the two exams. Assume that the students have a fixed number of hours in one evening to study for two large exams the following day. 1. What tradeoffs does a student face when deciding how to spend his or her time? 2. What factors should the student consider when making the decision regarding how to study? 3. Why might different students make different decisions regarding how to spend the hours studying? Class Discussion: Absolute and Comparative Advantage (LO 2.2) You can show the following clip during class from the TV show Suits. (Please note that there is a small bit of language in the clip that some may find objectionable). The page itself has some commentary on absolute and comparative advantage. In short, the boss does all the work overnight (showing his absolute advantage). 1. If the boss has the absolute advantage, why doesn’t he just do all the work? Writing Assignment: Specialization (LO 2.3) Have students read (or listen to the audio book for) I, Pencil by Leonard E. Read. Ask students to write a brief essay on why no single individual can personally produce even a seemingly simple product like a pencil. Class Activity: Gains from Trade (LO 2.4) A simple trading exercise can highlight the concept of gains from trade for students. Bring a few bags of chips or other snacks to class and distribute them to students (you may choose only a few students for this activity in a large lecture). 1. Ask each student to rate their satisfaction with the snack you’ve given them on a scale from 1-10, with 1 being highly dissatisfied and ten being highly satisfied. Record their answers somewhere where all students can see. 2. Ask the students if they want to trade, and give them a few minutes to interact and exchange snacks. (Remind them that it must be voluntary—they do not have to trade if they do not wish to.) 3. Ask the students about their satisfaction again, this time with their new snack. Have the students explain any changes in their answer from before. After trading, students should be at the very least equally as well off in terms of satisfaction as the first time they answered. This exercise can be used to highlight the gains from trade. You can also discuss the fact that the original distribution matters as well. This can tie into a number of discussions, including income distribution and comparative advantage. Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. A movement along the production possibilities frontier would imply that [LO 2.1] A. firms have more labor to produce goods B. new technology has improved production processes C. society chose a new combination of output to produce D. workers are taking more vacation days 2. Which of the following could cause an outward shift of the production possibilities curve? [LO 2.1] A. a decrease in productivity B. an increase in the amount of labor inputs available to firms C. a different choice of outputs produced by society D. an increase in the price of final goods that society can produce Feedback: Price increases won’t shift the PPF. Remember that the PPF simply shows what we CAN produce, not necessarily what we would WANT to produce. If a good has a higher price, that doesn’t automatically give us more capabilities to produce it! 3. The production possibilities frontier model illustrates which economic concept(s)? [LO 2.1] A. scarcity B. tradeoffs and choices C. opportunity cost D. all of the above 4. Gains from trade depend on [LO 2.4] A. absolute advantage B. comparative advantage C. finite vs. infinite production possibilities D. the willingness of individuals to specialize Feedback: Trade can occur even if one person (or country) has the absolute advantage in all goods. The gains come from comparative advantage, where we take advantage of the lowest opportunity costs. 5. The United States has a lot of land. Japan has very little land area compared to the United States. Compared to Japan, what output do you think the United States would most likely have an absolute and comparative advantage in producing? [LO 2.4] A. agricultural commodities B. smart phones C. automobiles D. clothing Solutions to End-of-Chapter Questions and Problems Review Questions 1. You’ve been put in charge of a bake sale for a local charity, at which you are planning to sell cookies and cupcakes. What would a production possibilities graph of this situation show? [LO 2.1] Answer: On one axis, the production possibilities graph would show the total number of cookies you could bake if you spent all of your time and resources baking cookies. The other axis would show the total amount of cupcakes you could bake if you spent all of your time and resources baking cupcakes. The two endpoints would be connected by a downwardsloping line. The slope of this line would represent the tradeoff (opportunity cost) you face between baking cookies and baking cupcakes. If you bake more cupcakes, you must bake fewer cookies. The production possibilities graph would show all of the combinations of cookies and cupcakes you could produce with your time and resources. 2. You manage two employees at a pet salon. Your employees perform two tasks, giving flea baths and grooming animals. If you constructed a single production possibilities frontier for flea baths and grooming that combined both of your employees’ work efforts, would you expect the production possibilities frontier to be linear (a straight line)? Explain why or why not. [LO 2.1] Answer: You would not expect a production possibilities frontier that combined both of your employees' work efforts to be linear. Each worker would likely differ in her relative skills at grooming and giving flea baths and would therefore differ in the opportunity cost for performing each task. 3. You and another volunteer are in charge of a bake sale for a local charity, at which you are planning to sell cookies and cupcakes. What would it mean for one of you to have an absolute advantage at baking cookies or cupcakes? Could one of you have an absolute advantage at baking both items? [LO 2.2] Answer: If you have an absolute advantage in the production of cupcakes (or cookies), it means that you can produce more cupcakes (or cookies) in total with the same amount of resources than the other volunteer. Absolute advantage is about having greater productivity. You could have an absolute advantage in baking both cupcakes and cookies if you are more productive in both goods than the other volunteer. 4. You and another volunteer are in charge of a bake sale for a local charity, at which you are planning to sell cookies and cupcakes. What would it mean for you or the other volunteer to have a comparative advantage at baking cookies or cupcakes? Could one of you have a comparative advantage at baking both items? [LO 2.2] Answer: If you had a comparative advantage in baking cookies, it would mean that you have a lower opportunity cost (you give up fewer cupcakes for each cookie you bake) than the other volunteer. It is not possible for you to have a comparative advantage in baking both goods. If you have a comparative advantage in baking cookies, the other volunteer will have a comparative advantage in baking cupcakes. 5. You and another volunteer are in charge of a bake sale for a local charity, at which you are planning to sell cookies and cupcakes. Suppose you have a comparative advantage at baking cookies, and the other volunteer has a comparative advantage at baking cupcakes. Make a proposal to the volunteer about how to split up the baking. Explain how you can both gain from specializing, and why. [LO 2.3] Answer: If you have a comparative advantage in baking cookies and the other volunteer has a comparative advantage in baking cupcakes, then you should specialize in baking cookies and the other volunteer should specialize in baking cupcakes. If you spend all of your time baking cookies and the other volunteer spends all of his time baking cupcakes, you will wind up with more cookies and cupcakes between you than you would have if you each spent half of your time baking each good. 6. At the flower shop, where you manage two employees, your employees perform two tasks: caring for the displays of cut flowers and making flower arrangements to fill customer orders. Explain how you would approach organizing your employees and assigning them tasks. [LO 2.3] Answer: You would have your employees specialize in the task for which they have the lowest opportunity cost. The worker who has the lower opportunity cost of caring for the displays should switch to filling customer orders only if there are orders left to complete after all the cut flowers have been cared for (water changed, old blooms removed, etc.). You would assign making floral arrangements to fill customer orders to the worker who has the comparative advantage in that task. This worker should fill customer orders and switch to caring for the cut flower displays only if there is such work left to complete after customer orders have been filled. 7. Suppose two countries produce the same two goods and have identical production possibilities frontiers. Do you expect these countries to trade? Explain why or why not. [LO 2.4] Answer: We would not expect countries with the same production possibilities frontiers to trade. Identical production possibilities frontiers would indicate that the two countries faced the same opportunity costs. The basis for gains from trade is specializing according to differing opportunity costs. 8. Brazil is the largest coffee producer in the world, and coffee is one of Brazil’s major export goods. Suppose that in 20 years, Brazil no longer produces much coffee and imports most of its coffee instead. Explain why Brazil might change its trade pattern over time. [LO 2.4] Answer: Brazil would change from exporting to importing coffee if its comparative advantage changes. Over time, Brazil could lose its comparative advantage in coffee if its opportunity costs for growing coffee increase. If this were the case, we would expect Brazil to gain a comparative advantage elsewhere. Problems and Applications 1. Your friend Sam has been asked to prepare appetizers for a university reception during homecoming weekend. She has an unlimited amount of ingredients but only six hours to prepare them. Sam can make 300 mini-sandwiches or 150 servings of melon slices topped with smoked salmon and a dab of sauce per hour. [LO 2.1] a. Draw Sam’s production possibilities frontier. b. Now suppose that the university decides to postpone the reception until after the big game, so Sam has an extra four hours to prepare. Redraw her production possibilities frontier to show the impact of this increase in resources. c. Now, in addition to the extra time to prepare, suppose Sam’s friend Chris helps by preparing the melon slices. Sam can now make 300 mini-sandwiches or 300 melon appetizers per hour. Redraw Sam’s production possibilities frontier to show the impact of increased productivity in making melon appetizers. Answer: a. 300 mini-sandwiches/hr = 1,800 mini-sandwiches in 6 hours. This is the endpoint on the Y-axis. 150 melon appetizers/hr = 900 melon appetizers in 6 hours. This is the endpoint on the X-axis. b. 300 mini-sandwiches/hr = 3,000 mini-sandwiches in 10 hours. This is the endpoint on the Y-axis. 150 melon appetizers/hr = 1,500 melon appetizers in 10 hours. This is the endpoint on the X-axis. c. 300 mini-sandwiches/hr = 3,000 mini-sandwiches in 10 hours. This is the endpoint on the Y-axis. 300 melon appetizers/hour = 3,000 melon appetizers in 10 hours. This is the endpoint on the X-axis. 2. Your friend Sam has been asked to prepare appetizers for the university reception. She has an unlimited amount of ingredients and six hours in which to prepare them. Sam can make 300 mini-sandwiches or 150 servings of melon slices topped with smoked salmon and a dab of sauce per hour. [LO 2.1] a. What is Sam’s opportunity cost of making one mini-sandwich? b. What is Sam’s opportunity cost of making one melon appetizer? c. Suppose the reception has been postponed, so Sam has an extra four hours to prepare. What is the opportunity cost of making one mini-sandwich now? d. Suppose the reception has been postponed, so Sam has an extra four hours to prepare. What is the opportunity cost of making one melon appetizer now? e. Suppose Sam’s friend Chris helps by preparing the melon slices, increasing Sam’s productivity to 300 mini-sandwiches or 300 melon appetizers per hour. What is the opportunity cost of making one mini-sandwich now? f. Suppose Sam’s friend Chris helps by pre-paring the melon slices, increasing Sam’s productivity to 300 mini-sandwiches or 300 melon appetizers per hour. What is the opportunity cost of making one melon appetizer now? Answer: The opportunity cost is the value of what you have to give up in order to get something. It is the value of your next-best alternative. a. To make 1 more mini-sandwich you have to give up 1/2 melon appetizer. b. To make 1 more melon appetizer you have to give up 2 mini-sandwiches. c. To make 1 more mini-sandwich you still have to give up 1/2 melon appetizer. The opportunity cost has not changed. d. To make 1 more melon appetizer you still have to give up 2 mini-sandwiches. e. To make 1 more mini-sandwich you have to give up 1 melon appetizer. The opportunity cost has changed. f. To make 1 more melon appetizer you have to give up 1 mini-sandwich. 3. Suppose that Canada produces two goods: lumber and fish. It has 18 million workers, each of whom can cut 10 feet of lumber or catch 20 fish each day. [LO 2.1] a. What is the maximum amount of lumber Canada could produce in a day? b. What is the maximum amount of fish it could produce in a day? c. Draw Canada’s production possibilities frontier. d. Use your graph to determine how many fish can be caught if 60 million feet of lumber are cut. Answer: a. The maximum amount of lumber Canada could produce in a day is 10 feet x 18 million workers = 180 million feet. b. The maximum amount of fish Canada could produce in a day is 20 fish x 18 million workers = 360 million fish. c. The two endpoints of the PPF are (0,180) and (360,0). d. The opportunity cost of producing 1 foot of lumber is 2 fish. Therefore, the opportunity cost of producing 60 million feet of lumber is 120 million fish. If Canada produces 60 million feet of lumber, then it can only produce 360 - 120, or 240 million fish. 4. The graph in Figure 2P-1 shows Tanya’s weekly production possibilities frontier for doing homework (writing papers and doing problem sets). [LO 2.1] a. What is the slope of the production possibilities frontier? b. What is the opportunity cost of doing one problem set? c. What is the opportunity cost of writing one paper? Answer: a. The slope of the production possibilities frontier is -(6/2) = -3. b. The opportunity cost of doing one problem set is (2 papers/6 problems sets) = 1/3 paper. c. The opportunity cost of writing one paper is (6 problems sets/2 papers) = 3 problems sets. 5. Use the production possibilities frontier in Figure 2P-2 to answer the following questions. [LO 2.1] a. What is the slope of the PPF between point A and point B? b. What is the slope of the PPF between point B and point C? c. Is the opportunity cost of producing hammers higher between points A and B or between points B and C? d. Is the opportunity cost of producing screwdrivers higher between points A and B or between points B and C? Answer: a. The slope of the production possibilities frontier between Point A and Point B is -(5/1) = -5. b. The slope of the production possibilities frontier between Point B and Point C is -(10/1) = -10. c. The opportunity cost of producing hammers is lower between points A and B (5 hammers) than between points B and C (10 hammers). d. The opportunity cost of producing screwdrivers is higher between points A and B (1/5 screwdriver) than between points B and C (1/10 screwdriver). 6. For each point on the PPF in Figure 2P-3, note whether the point is attainable and efficient, attainable and inefficient, or unattainable. [LO 2.1] Answer: Points that lie on the frontier are called efficient, because they squeeze the most output possible from all available resources. Points within (inside) the frontier are inefficient because they do not use all available resources. Points outside the frontier are unattainable with current resources. a. Attainable and efficient. b. Unattainable. c. Attainable and inefficient. d. Attainable and efficient. 7. For each point on the PPF in Figure 2P-4, note whether the point is attainable and efficient, attainable and inefficient, or unattainable. [LO 2.1] Answer: Points that lie on the frontier are called efficient, because they squeeze the most output possible from all available resources. Points within (inside) the frontier are inefficient because they do not use all available resources. Points outside the frontier are unattainable with current resources. a. Attainable and efficient. b. Attainable and efficient. c. Attainable and efficient. d. Attainable and inefficient. e. Unattainable. 8. The Red Cross and WIC (Women, Infants, and Children program) both provide emergency food packages and first-aid kits to New York City home-less shelters. Table 2P-1 shows their weekly production possibilities in providing emergency goods to NYC homeless shelters. NYC homeless shelters need a total of 20 first-aid kits per week. Currently, they get 10 kits from the Red Cross and 10 kits from WIC. With their remaining resources, how many food packages can each organization provide to NYC homeless shelters? [LO 2.1] Answer: From the table, we find that the Red Cross can produce 300 food packages OR 50 first-aid kits OR some combination in-between (for example, 150 food packages and 25 firstaid kits.) The opportunity cost of providing one first-aid kit is 6 food packages. The requirement of 10 kits from the Red Cross comes at a cost of 60 food packages (6 food packages per first-aid kit times 10). Out of the 300 food packages possible from the Red Cross 60 must be given up, leaving 240 (300 - 60) food packages available. Likewise, the WIC can produce 200 food packages OR 20 first-aid kits OR some combination in-between. The opportunity cost for this organization of providing one first-aid kit is 10 food packages. The requirement of 10 first-aid kits from the WIC means giving up 100 food packages. Out of the 200 food packages possible, 100 (200 - 100) are still available. 9. Suppose that three volunteers are preparing cookies and cupcakes for a bake sale. Diana can make 27 cookies or 18 cupcakes per hour; Andy can make 25 cookies or 17 cupcakes; and Sam can make 10 cookies or 12 cupcakes. [LO 2.2] a. Who has the absolute advantage at making cookies? b. At making cupcakes? Answer: If a producer can generate more output than others with a given amount of resources, that producer has an absolute advantage. When a producer can make a good at a lower opportunity cost than other producers, we say it has a comparative advantage at producing that good. a. Of the three workers, Diana has the absolute advantage at making cookies. She can make the most cookies (27) in an hour compared with Andy (25) and Sam (10). b. Diana also has the absolute advantage at baking cupcakes. She can bake 18 cupcakes in an hour, whereas Andy can only bake 17 and Sam can only bake 12. 10. Paula and Carlo are coworkers. Their production possibilities frontiers for counseling clients and writing memos are given in Figure 2P-5. [LO 2.2] a. Which worker has an absolute advantage in counseling clients? b. Which worker has an absolute advantage in writing memos? c. Which worker has a comparative advantage in counseling clients? d. Which worker has a comparative advantage in writing memos? Answer: Absolute advantage is the ability to produce more of a good or service than others can with a given amount of resources. Comparative advantage is the ability to produce a good or service at a lower opportunity cost than others. a. Paula has the absolute advantage in counseling clients because she can produce more of this service than Carlo can with a given amount of resources. b. Paula has the absolute advantage in writing memos because she can write more of them than Carlo can with a given amount of resources. c. Paula has the comparative advantage in counseling clients because her opportunity cost of counseling a client is 0.25 memos compared to Carlo's opportunity cost of 0.33 memos. d. Carlo has the comparative advantage in writing memos because his opportunity cost of writing a memo is 3 counseled clients compared to Paula's opportunity cost of 4 counseled clients. 11. Two students are assigned to work together on a project that requires both writing and an oral presentation. Steve can write 1 page or prepare 3 minutes of a presentation each day. Anna can write 2 pages or prepare 1 minute of a presentation each day. [LO 2.2] a. Who has a comparative advantage at writing? b. Suppose that Steve goes to a writing tutor and learns some tricks that enable him to write 3 pages each day. Now who has a comparative advantage at writing? Answer: Absolute advantage is the ability to produce more of a good or service than others can with a given amount of resources. Comparative advantage is the ability to produce a good or service at a lower opportunity cost than others. a. Anna has a comparative advantage at writing because she has the lower opportunity cost. She gives up 0.5 minutes of presentation for each page she writes, whereas Steve gives up 3 minutes of presentation for each page he writes. b. If Steve goes to a writing tutor and increases his productivity in writing, his opportunity costs change. If Steve is now able to write 3 pages a day, it means his opportunity cost for each page he writes is now 1 minute of presentation. However, Anna still has a comparative advantage at writing because she still only gives up 0.5 minutes of presentation for each page he writes. 12. Suppose that the manager of a restaurant has two new employees, Rahul and Henriette, and is trying to decide which one to assign to which task. Rahul can chop 20 pounds of vegetables or wash 100 dishes per hour. Henriette can chop 30 pounds of vegetables or wash 120 dishes. [LO 2.3] a. Who should be assigned to chop vegetables? b. Who should be assigned to wash dishes? Answer: Comparative advantage is the ability to produce a good or service at a lower opportunity cost than others. a. Henriette should chop vegetables, as she has the lower opportunity cost for chopping vegetables. Henriette’s opportunity cost for chopping 1 vegetable is a loss of 4 dishes washed, whereas Rahul’s opportunity cost for chopping 1 vegetable is a loss of 5 dishes washed. b. Rahul should be assigned to wash dishes, as she has the lowest opportunity cost for washing dishes. Rahul’s opportunity cost for washing 1 dish is a loss of 0.2 vegetables chopped, whereas Henriette’s opportunity cost for washing 1 dish is a loss 0.25 vegetables chopped. 13. The Dominican Republic and Nicaragua both produce coffee and rum. The Dominican Republic can produce 20 thousand tons of coffee per year or 10 thousand barrels of rum. Nicaragua can produce 30 thousand tons of coffee per year or 5 thousand barrels of rum. [LO 2.3] a. Suppose the Dominican Republic and Nicaragua sign a trade agreement in which each country would specialize in the production of either coffee or rum. Which country should specialize in producing coffee? Which country should specialize in producing rum? b. What are the minimum and maximum prices at which these countries will trade coffee? Answer: a. If the Dominican Republic and Nicaragua sign a trade agreement in which each country would specialize in production, coffee and rum will be produced according to which country has a comparative advantage in the production of each good. Comparing their opportunity costs for producing coffee, we see that Nicaragua has a lower opportunity cost for producing coffee (1/6 of a barrel of rum, versus the Dominican Republic's opportunity cost of 1/2 barrel of rum). Nicaragua, therefore, should specialize in coffee. Comparing their opportunity costs for producing rum, we see that the Dominican Republic has a lower opportunity cost for producing rum (2 tons of coffee, versus 6 tons for Nicaragua). The Dominican Republic, therefore, should specialize in rum. b. The minimum price at which these countries will trade coffee is 1/6 (0.167) of a barrel of rum per ton of coffee and the maximum price is 1/2 (0.500) of a barrel of rum per ton of coffee. The price of coffee will end up between the opportunity costs for the two countries. Nicaragua specializes in coffee because it has the lower opportunity cost (1/6 as compared to 1/2). It will not sell coffee for less than its opportunity cost. The Dominican Republic will not pay more than its opportunity cost (1/2) because if the price of coffee was higher than 1/2 of a barrel of rum, then it would be better off producing the coffee itself. 14. Eleanor and her little sister Joanna are responsible for two chores on their family’s farm: gathering eggs and collecting milk. Eleanor can gather 9 dozen eggs or collect 3 gallons of milk per week. Joanna can gather 2 dozen eggs or collect 2 gallons of milk per week. [LO 2.3] a. The family wants 2 gallons of milk per week and as many eggs as the sisters can gather. Currently, Eleanor and Joanna collect one gallon of milk each and as many eggs as they can. How many dozens of eggs does the family have per week? b. If the sisters specialized, which sister should collect the milk? c. If the sisters specialized, how many dozens of eggs would the family have per week? Answer: Comparative advantage is the ability to produce a good or service at a lower opportunity cost than others. a. Eleanor’s opportunity cost for collecting a gallon of milk is 3 dozen eggs. Therefore Eleanor will gather 9-3 = 6 dozen eggs. Joanna’s opportunity cost for collecting a gallon of milk is 1 dozen eggs. Therefore, Joanna will gather 2-1 = 1 dozen eggs. Together the sisters will gather 7 bushels of apples. b. Joanna should specialize in collecting milk because she has the lower opportunity cost. c. If they specialize, Joanna will collect both gallons of milk and no eggs. Eleanor will collect 9 dozen eggs and no milk. The family will now have 9 dozen eggs with their 2 gallons of milk, more than they were able to have before the sisters specialized. 15. Suppose Russia and Sweden each produces only paper and cars. Russia can produce 8 tons of paper or 4 million cars each year. Sweden can produce 25 tons of paper or 5 million cars each year. [LO 2.4] a. Draw the production possibilities frontier for each country. b. Both countries want 2 million cars each year and as much paper as they can produce along with 2 million cars. Find this point on each production possibilities frontier and label it “A.” c. Suppose the countries specialize. Which country will produce cars? d. Once they specialize, suppose they work out a trade of 2 million cars for 6 tons of paper. Find the new consumption point for each country and label it “B.” Answer: a. The production possibilities frontier identifies the different combinations of the two goods (cars and paper) that can be produced by each country. Russia can produce 8 tons of paper and 0 cars or 0 tons of paper and 4 million cars. These are the two endpoints of Russia's PPF. Sweden can produce 25 tons of paper and 0 cars or 0 tons of paper and 5 million cars. These are the two endpoints of Sweden's PPF. b. If Russia wants to produce 2 million cars then they are only able to produce 4 tons of paper. If Sweden wants to produce 2 million cars then they are only able to produce 15 tons of paper. Notice Russia's opportunity cost of producing 1 million cars is 2 tons of paper, and Sweden's opportunity cost of producing 1 million cars is 5 tons of paper c. Russia will produce cars because Russia has a lower opportunity cost for producing cars than Sweden. d. Russia will produce 4 million cars (complete specialization is assumed) and trade 2 million cars to Sweden in exchange for 6 tons of paper. Therefore, Russia ends up consuming 2 million cars and 6 tons of paper. Sweden will produce 25 tons of paper and trade 6 tons of paper to Russia in exchange for 2 million cars. Therefore, Sweden ends up consuming 2 million cars and 19 tons of paper. Both counties are better of with trade because they still have 2 million cars each, but both end up with more paper than they had before trade. Notice the post-trade consumption point is outside the production possibilities frontier meaning each country was unable to achieve this point without trade. 16. Maya and Max are neighbors. They both grow lettuce and tomatoes in their gardens. Maya can grow 45 heads of lettuce or 9 pounds of tomatoes this summer. Max can grow 42 heads of lettuce or 6 pounds of tomatoes this summer. If Maya and Max specialize and trade, the price of tomatoes (in terms of lettuce) would be as follows: 1 pound of tomatoes would cost between __ and __ heads of lettuce. Answer: If Maya and Max specialize and trade, the price of tomatoes (in terms of lettuce) would be: 1 pound of tomatoes would cost between 5 and 7 heads of lettuce. Maya will grow tomatoes because she has the lower opportunity cost. (Maya’s opportunity cost is 5 heads of lettuce for 1 pound of tomatoes, whereas Max’s is 7 heads of lettuce for 1 pound of tomatoes.) She must receive at least 5 heads of lettuce from Max for a pound of tomatoes or she is better off growing the lettuce herself. Max will buy tomatoes from Maya but only if she charges him no more than 7 heads of lettuce. Otherwise, Max is better off growing the tomatoes himself. If, for example, Maya charges Max 6 heads of lettuce for a pound of tomatoes both neighbors would be better off than what they can do on their own. CHAPTER 3 MARKETS Chapter Overview By the time you reach the end of this course, you’ll be quite familiar with the words supply and demand. We take our time on this subject for good reason: An understanding of supply and demand is the foundation of economic problem solving. You’ll be hard-pressed to make wise economic choices without it. Although markets are not always perfectly competitive, you may be surprised at how accurately many real-world phenomena can be described using the simple rules of supply and demand. In the next chapters we’ll use these rules to explain how consumers and producers respond to price changes and government policies. Learning Objectives LO 3.1: Identify the defining characteristics of a competitive market. LO 3.2: Draw a demand curve and describe the external factors that determine demand. LO 3.3: Distinguish between a shift in and a movement along the demand curve. LO 3.4: Draw a supply curve and describe the external factors that determine supply. LO 3.5: Distinguish between a shift in and a movement along the supply curve. LO 3.6: Explain how supply and demand interact to drive markets to equilibrium. LO 3.7: Evaluate the effect of changes in supply and demand on the equilibrium price and quantity. Chapter Outline OPENING STORY: MOBILES GO GLOBAL Markets What Is a Market? What Is a Competitive Market? (LO 3.1) Demand The Demand Curve (LO 3.2) Determinants of Demand BOX FEATURE: REAL LIFE – CAN INSTANT-NOODLE SALES PREDICT A RECESSION? Shifts in the Demand Curve (LO 3.3) Supply The Supply Curve (LO 3.4) Determinants of Supply Shifts in the Supply Curve (LO 3.5) Market Equilibrium Reaching Equilibrium (LO 3.6) BOX FEATURE: REAL LIFE – THE PRIUS SHORTAGE OF 2003 Changes in Equilibrium (LO 3.7) BOX FEATURE: REAL LIFE – GIVE A MAN A FISH Beyond the Lecture Class Discussion: Shifts versus Movements in Demand and Supply (LO 3.3, LO 3.5) Consider discussing the past prohibition of alcohol in the United States to stimulate a conversation about changes in supply, demand, and price. This topic can also be used to highlight the difference between shifts in demand and supply and movements along the demand and supply curves. 1. Ask students how they think the introduction of prohibition impacted demand, supply, and price. 2. Ask students if other things remained constant. 3. Ask students to consider what occurred when prohibition was repealed. This can be extended to consider any prohibited goods or services. Students generally find this conversation interesting. There are numerous examples in popular media that can be paired with this discussion. For example, consider showing a clip from an episode of The Simpsons, Homer vs. the Eighteenth Amendment (Season 8, Episode 18), from 8:50 to 12:40. Class Discussion: Supply, Demand, and Equilibrium (LO 3.7) Show students a brief clip from the television show The Office to highlight supply and demand. In this episode, there is a doll that is a very popular gift item during the holiday season. Dwight buys all of the dolls in the area and resells them to parents, charging a price above the retail price, but one which parents are gladly willing to pay. A short video of this is hosted at the “Economics of the Office” website, authored by Dan Kuester of Kansas State University. The video link is here. Class Activity: Building a Demand Curve (LO 3.2) A great activity to do in class is to have an auction to build a demand curve. The day before the auction, tell students to bring their money to class next time. You can create a “bundle” of goods (candy, soda, chips, popcorn) and auction of the one lot to the highest bidder. Start by taking a show of hands for people who would pay a super low price, such as 25 cents or $1 for your bundle. Then, when the price gets to $5, auction off the good. You can collect data as you go along. Some notes: 1. You actually need to have the winner pay real money. They are getting real goods in exchange. We need to reveal the real demand curve for your class. 2. A link to a video example of this is here, provided by Dave Brown of Pennsylvania State University. 3. Additionally, you may get students asking you how much you paid for the bundle. It is most likely that the winning bid is far above the price you paid for the goods. You can use this to illustrate consumer and producer surplus as well. Class Discussion/Class Activity: Supply, Demand, and Equilibrium (LO 3.7) Ask students to think about the price of tickets to popular athletic events, concerts, etc. Have them think about the sticker price of the ticket relative to the price that they might have to pay to acquire the ticket. Consider showing them Stubhub, a popular online ticket resale website. 1. How much do tickets for really popular events tend to sell for online, relative to the retail price of the ticket? 2. Why don’t the original sellers of the tickets just charge a higher price? 3. How do ticket resellers impact the market? Are resellers helping or harming buyers? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. Clickers may be especially important with this chapter, as understanding demand and supply is one of the key objectives taught in basic economics. This is especially true regarding the difference between a movement along a demand (supply) curve and a shift in demand (supply). 1. A competitive market generally means that [LO 3.1] A. the sellers solely determine price. B. trading results in a winner and loser. C. fully-informed buyers and sellers act as price-takers. D. buyers fiercely compete to buy available goods. 2. The law of demand states that [LO 3.2] A. there is an inverse relationship between price and quantity demanded. B. consumers don’t buy expensive goods. C. there is a direct relationship between consumer income and consumption of a good. D. consumers’ preferences will be similar. Feedback: While answer [C] may be true for normal goods, this is not what the law of demand states. The law of demand just illustrates the downward sloping nature of the demand function. 3. Which of the following will cause an increase in demand (rightward shift)? [LO 3.3] A. A decrease in the price of the good B. An increase in the price of the good C. An increase in consumer preferences for the good D. A decrease in the price of a substitute good Feedback: Careful! Many people may incorrectly choose [A] for their answer. A change in the price causes a movement along a demand curve. Changes in other factors cause a shift. Answer choice [D] results in a leftward shift. 4. Prices below equilibrium will result in [LO 3.6] A. more government regulations on the market. B. a shortage. C. a surplus. D. firms working together to raise the price. 5. Suppose a market is in equilibrium. If there is a decrease in demand, we expect [LO 3.7] A. that the equilibrium will not change. B. a higher equilibrium price, but the same equilibrium quantity. C. firms to see fewer goods. D. a higher equilibrium price and higher equilibrium quantity. Feedback: The rightward demand shift leads to a new equilibrium point with a higher price and quantity. Solutions to End-of-Chapter Questions and Problems Review Questions 1. Think about a competitive market in which you participate regularly. For each of the characteristics of a competitive market, explain how your market meets these requirements. [LO 3.1] Answer: The market for eggs is competitive. There are many grocery stores where eggs can be purchased. Standardized good: Eggs are a standardized good. There are different kinds of eggs, of course, but each unit of a particular type of egg will be standardized. Full information: The ubiquity of grocery stores makes it easy for buyers and sellers to gather information about the price of eggs. No transaction costs: There are no transaction costs or other limits to buying and selling eggs. Buyers and sellers can easily find each other. Participants are price takers: I am one consumer among many and my purchase patterns have no effect on the market price. Likewise, there are so many places to buy eggs that sellers are also price takers. 2. Think about a noncompetitive market in which you participate regularly. Explain which characteristic(s) of competitive markets your market does not meet. [LO 3.1] Answer: I take the subway to work every day. Public transportation is not a competitive market. There is only one subway system, so there is no competition. The subway is a natural monopoly (students will learn about monopolies in a later chapter). For now, it is enough to know that without competition, the MTA (Metropolitan Transportation Authority)--which operates the subway system--is not a price taker. The passengers are certainly price takers, but the operator is not. 3. Explain why a demand curve slopes downward. [LO 3.2] Answer: The demand curve slopes downward because as prices increase, quantity demanded decreases. Price and quantity move in opposite directions and have a negative relationship for demand. Think about your incentives when the price of a good you want to purchase increases. The quantity you demand of that good is likely to move in the other direction and decrease. When price and quantity move in opposite directions, the result is a downward sloping curve. 4. In each of the following examples, name the factor that affects demand and describe its impact on your demand for a new cell phone. [LO 3.2] a. You hear a rumor that a new and improved model of the phone you want is coming out next year. b. Your grandparents give you $500. c. A cellular network announces a holiday sale on a data package that includes the purchase of a new smartphone. d. A friend tells you how great his new phone is and suggests that you get one, too. Answer: a. Expectations. Your current demand will decrease in the present as you postpone purchasing under the expectation that a new model will be released next year. b. Incomes. Your purchasing power has increased due to the money given to you by your grandparents. Your demand will increase. c. Price of a Related Good. When the price of a data package (a complementary good) goes down due to the sale, demand for smartphones increases. d. Consumer Preferences. Your friend influences your interest in purchasing a phone. Your friend’s enjoyment of his phone and suggestion that you also purchase a phone increases your demand. 5. Consider the following events: a. The price of cell phones goes down by 25 percent during a sale. b. You get a 25 percent raise at your job. c. Which event represents a shift in the demand curve? Which represents a movement along the curve? What is the difference? [LO 3.3] Answer: The relationship between price and quantity demanded is directly reflected in the demand curve. A change in price will mean a movement along an existing curve. Factors of demand that are held constant, such as income, cause a shift in the demand curve when they change. a. When the price of cell phones goes down by 25 percent, this is a movement along the demand curve for cell phones. b. When your income increases by 25 percent, there is a shift in the demand curve, as income is a factor of demand held constant in any given demand curve. 6. What is the difference between a change in demand and a change in quantity demanded? [LO 3.3] Answer: When we refer to a change in demand, we are referring to a shift of the entire curve. This happens when a non-price factor changes--such as income, expectations, prices of related goods, consumer preferences or the number of buyers. A change in quantity demanded refers to a change in the specific numerical quantity demanded due to a change in price. 7. Explain why a supply curve slopes upward. [LO 3.4] Answer: The supply curve slopes upward because as prices increase, quantity supplied also increases. Price and quantity move in the same direction and have a positive relationship for supply. Think about the incentives facing a producer when the price of the good she is producing increases. The quantity she is willing and able to supply of that good is likely to also increase. When price and quantity move in the same direction, the result is an upward sloping curve. 8. In each of the following examples, name the factor that affects supply and describe its impact on the supply of cell phones. [LO 3.4] a. Economic forecasts suggest that the demand for cell phones will increase in the future. b. The price of plastic goes up. c. A new screen technology reduces the cost of making cell phones. Answer: a. Expectations. If demand for cell phones is expected to increase in the future, then the price of cell phones is expected to increase in the future. Current supply of cell phones may decrease if supplies are able to withhold inventory waiting on prices to increase. Supply of cell phones will eventually increase as prices do rise. b. Prices of Inputs. Plastic is an input in the production of cell phones. If the price of plastic increases production costs increase and supply decreases. c. Technology. If advancement in screen technology reduces the cost of making cell phones, supply of cell phones will increase. 9. Consider the following events: a. A maggot infestation ruins a large number of apple orchards in Washington state. b. Demand for apples goes down, causing the price to fall. c. Which event represents a shift in the supply curve? Which represents a movement along the curve? What is the difference? [LO 3.5] Answer: Factors of supply that are held constant, such as number of suppliers, cause a shift in the supply curve when they change. The relationship between price and quantity supplied is directly reflected in the supply curve. A change in price will mean a movement along an existing curve. a. A fruitworm infestation will cause a shift in the supply of apples, as the number of orchards (sellers) able to supply to the market will decrease. b. When demand decreases and prices fall, there is a movement along the supply curve. 10. What is the difference between a change in supply and a change in quantity supplied? [LO 3.5] Answer: When we refer to a change in supply, we are referring to a shift of the entire curve. This happens when a non-price factor changes--such as technology, expectations, prices of related goods, prices of inputs or the number of sellers. A change in quantity supplied refers to a change in the specific numerical quantity supplied due to a change in price. 11. What is the relationship between supply and demand when a market is in equilibrium? Explain how the incentives facing cell phone companies and consumers cause the market for cell phones to reach equilibrium. [LO 3.6] Answer: When a market is in equilibrium, quantity supplied equals quantity demanded. We say that supply and demand are in agreement at market equilibrium. Cell phone sellers have an incentive for prices to rise and cell phone consumers would like for prices to fall. Because their incentives are not aligned, each side will create opposing pressure on market prices. Equilibrium represents the price at which both consumers and suppliers of cell phones agree to buy/sell a given quantity. 12. Explain why the equilibrium price is often called the market-clearing price. [LO 3.6] Answer: The equilibrium price is often called the market clearing price because it is the price at which the market “clears” in the sense that there is neither excess demand nor excess supply. Quantity supplied equals quantity demanded at this price. Every buyer who wants to buy at this price can find supply and every supplier who wants to sell at this price can find a buyer. 13. Suppose an economic boom causes incomes to increase. Explain what will happen to the demand and supply of phones, and predict the direction of the change in the equilibrium price and quantity. [LO 3.7] Answer: If incomes increase, there will be an increase in demand for cell phones. If no other shifts occurred, both the price of cell phones and the quantity of cell phones traded would rise. 14. Suppose an economic boom drives up wages for the sales representatives who work for cell phone companies. Explain what will happen to the demand and supply of phones, and predict the direction of the change in the equilibrium price and quantity. [LO 3.7] Answer: If an increase in wages causes an increase in production costs for sellers of cell phones, supply of cell phones will decrease. If no other shifts had occurred, a decrease in supply would cause prices to rise and the number of cell phones traded to decrease. 15. Suppose an economic boom causes incomes to increase and at the same time drives up wages for the sales representatives who work for cell phone companies. Explain what will happen to the demand for and supply of phones and predict the direction of the change in the equilibrium price and quantity. [LO 3.7] Answer: When both an increase in demand and a decrease in supply occur, we know that the price of cell phones will rise. It is unclear whether the quantity of cell phones traded will increase or decrease. It depends on whether the shift in demand is larger or smaller than the shift in supply. Problems and Applications 1. Consider shopping for cucumbers in a farmers’ market. For each statement below, note which characteristic of competitive markets the statement describes. Choose from: standardized good, full information, no transaction costs, and participants are price takers. [LO 3.1] a. All of the farmers have their prices posted prominently in front of their stalls. b. Cucumbers are the same price at each stall. c. There is no difficulty moving around between stalls as you shop and choosing between farmers. d. You and the other customers all seem indifferent about which cucumbers to buy. Answer: A standardized good is a good for which any two units have the same features and are interchangeable. In a competitive market, you have full information about the price and features of the good being bought and sold. In competitive markets, there are no transaction costs, meaning that you don’t have to pay anything for the privilege of buying or selling in the market. In economic terminology, a buyer or seller who cannot affect the market price is called a price taker. a. Full information. b. Participants are price takers. c. No transaction costs. d. Standardized good. 2. Suppose two artists are selling paintings for the same price in adjacent booths at an art fair. By the end of the day, one artist has nearly sold out of her paintings while the other artist has sold nothing. Which characteristic of competitive markets has not been met and best explains this outcome? [LO 3.1] a. Standardized good. b. Full information. c. No transaction costs. d. Participants are price takers. Answer: A standardized good is a good for which any two units have the same features and are interchangeable. In a competitive market, you have full information about the price and features of the good being bought and sold. In competitive markets, there are no transaction costs, meaning that you don’t have to pay anything for the privilege of buying or selling in the market. In economic terminology, a buyer or seller who cannot affect the market price is called a price taker. This is not a standardized good. The booths are adjacent with prices clearly posted so full information is available without transaction costs. The prices of the paintings are the same, which may indicate that the artists are price-takers. The best explanation for the difference in sales is that the paintings are not standardized. The artists may have very different styles or levels of talent. 3. Using the demand schedule in Table 3P-1, draw the daily demand curve for slices of pizza in a college town. [LO 3.2] Answer: 4. Consider the market for cars. Which determinant of demand is affected by each of the following events? Choose from: consumer preferences, prices of related goods, incomes, expectations, and the number of buyers. [LO 3.2] a. Environmentalists launch a successful One Family, One Car campaign. b. A baby boom occurred 16 years ago. c. Layoffs increase as the economy sheds millions of jobs. d. An oil shortage causes the price of gasoline to soar. e. The government offers tax rebates in return for the purchase of commuter rail tickets. f. The government announces a massive plan to bail out the auto industry and subsidize production costs. Answer: The non-price determinants of demand can be divided into five major categories: consumer preferences, the prices of related goods, incomes, expectations of future prices, and the number of buyers in the market. Determinant of Demand Increase in Demand Decrease in Demand Consumer preferences A Buy American ad campaign appeals to national pride, increasing the demand for U.S.-made sneakers. An outbreak of E.coli decreases the demand for spinach. Prices of related goods A decrease in the price of hot dogs increases the demand for relish, a complementary good. A decrease in taxi fares decreases the demand for subway rides, a substitute good. Incomes An economic downturn lowers incomes, increasing the demand for ground beef, an inferior good. An economic downturn lowers incomes, decreasing the demand for steak, a normal good. Expectations A hurricane increases the demand for papaya, because food prices are expected to rise after crops are destroyed. An announcement that a new smart phone soon will be released decreases the demand for the current model. Number of buyers An increase in life expectancy increases the demand for nursing homes and medical care. A falling birthrate decreases the demand for diapers. a. Consumer preferences. b. Number of buyers. c. Incomes. d. Prices of related goods. e. Prices of related goods. f. Expectations. 5. If a decrease in the price of laptops causes the demand for tablets to increase, are laptops and tablets substitutes or complements? [LO 3.2] Answer: If a decrease in the price of laptops causes the demand for tablets to increase, laptops and tablets are complements. A decrease in the price of laptops increases the quantity demanded for laptops (a movement along the curve). If the demand for tablets also increases (a shift of the curve), consumers use laptops and tablets together. 6. If rising incomes cause the demand for beer to decrease, is beer a normal or inferior good? [LO 3.2] Answer: If rising incomes cause the demand for beer to decrease, beer is an inferior good. If this is the case for beer, this could be because consumers substitute preferred drinks such as wine or liquor when their income rises. 7. Consider the market for corn. Say whether each of the following events will cause a shift in the demand curve or a movement along the curve. If it will cause a shift, specify the direction. [LO 3.3] a. A drought hits corn-growing regions, cutting the supply of corn. b. The government announces a new subsidy for biofuels made from corn. c. A global recession reduces the incomes of consumers in poor countries, who rely on corn as a staple food. d. A new hybrid variety of corn seed causes a 15 percent increase in the yield of corn per acre. e. An advertising campaign by the beef producers’ association highlights the health benefits of corn-fed beef. Answer: A change in the price of a good will cause a movement along the demand curve. A change in a nonprice determinant will cause a shift of the demand curve. a. Movement along the curve: There is a decrease in supply, which causes an increase in price and a decrease in quantity demanded. b. Shift in the curve: There is an increase in demand (rightward shift). c. Shift in the curve: There is a decrease in demand (leftward shift). d. Movement along the curve: There is an increase in supply, which causes a decrease in price and an increase in quantity demanded. e. Shift in the curve: There is an increase in demand (rightward shift). 8. The demand curve in Figure 3P-1 shows the monthly market for sweaters at a local clothing store. For each of the following events, draw the new outcome. [LO 3.3] a. Sweaters fall out of fashion. b. There is a shortage of wool. c. The winter is particularly long and cold this year. d. Sweater vendors offer a sale. Answer: a. Point D: This is a change in a nonprice determinant. The demand curve will shift to the left because people prefer to buy fewer sweaters. b. Point B: A shortage of wool will increase the price of sweaters and the supply curve will shift left, causing a movement up along the demand curve. c. Point E: This is a change in a nonprice determinant. The demand curve will shift to the right as people prefer to buy more sweaters. d. Point C: The price of sweaters decreases and the supply curve will shift right, causing a movement down along the demand curve. 9. Using the supply schedule found in Table 3P-2, draw the daily supply curve for slices of pizza in a college town. [LO 3.4] Answer: The supply schedule shows the quantity of pizza slices that firms are willing and able to sell (supply) at various prices. Each price - quantity combination from the supply schedule can be plotted on the graph to illustrate the supply curve. 10. Consider the market for cars. Which determinant of supply is affected by each of the following events? Choose from: prices of related goods, technology, prices of inputs, expectations, and the number of sellers in the market. [LO 3.4] a. A steel tariff increases the price of steel. b. Improvements in robotics increase efficiency and reduce costs. c. Factories close because of an economic downturn. d. The government announces a plan to offer tax rebates for the purchase of commuter rail tickets. e. The price of trucks falls, so factories produce more cars. f. The government announces that it will dramatically rewrite efficiency standards, making it much harder for automakers to produce their cars. Answer: Several non-price factors determine the supply of a good at any given price: They include the prices of related goods, technology, prices of inputs, expectations about the future, and the number of sellers in the market. Determinant of Supply Increases in Supply Decreases in Supply Price of related goods The price of gas rises, so an automaker increases its production of smaller, more fuel-efficient cars. The price of clean energy production falls, so the power company reduces the amount of power it supplies using coal power plants. Technology The installation of robots increases productivity and lowers costs; the supply of goods increases. New technology allows corn to be made into ethanol, so farmers plant more corn and fewer soybeans; the supply of soybeans decreases. Prices of inputs A drop in the price of tomatoes decreases the production cost of salsa; the supply of salsa increases. An increase in the minimum wage increases labor costs at food factories; the supply of processed food decreases. Expectations Housing prices are expected to rise, so builders increase production; the supply of houses increases. New research points to the deleterious effect of eating papayas, leading to expectations that the demand for papayas will fall. Fewer farmers plant papayas, decreasing the supply. Number of Sellers Subsidies make the production of corn more profitable, so more farmers plant corn; the supply of corn increases. New licensing fees make operating a restaurant more expensive; some small restaurants close, decreasing the supply of restaurants. a. Prices of inputs. b. Technology. c. Number of sellers. d. Expectations. e. Prices of related goods. 11. Consider the market for corn. Say whether each of the following events will cause a shift in the supply curve or a movement along the curve. If it will cause a shift, specify the direction. [LO 3.5] a. A drought hits corn-growing regions. b. The government announces a new subsidy for biofuels made from corn. c. A global recession reduces the incomes of consumers in poor countries, who rely on corn as a staple food. d. A new hybrid variety of corn seed causes a 15 percent increase in the yield of corn per acre. e. An advertising campaign by the beef producers’ association highlights the health benefits of corn-fed beef. Answer: A change in the price of a good will cause a movement along the supply curve. A change in a non-price determinant will cause a shift of the supply curve. a. Shift in the curve: There is a decrease in supply (leftward shift). b. Movement along the curve: There is an increase in demand. c. Movement along the curve: There is a decrease in demand. d. Shift in the curve: There is an increase in supply (rightward shift). e. Movement along the curve: There is an increase in demand. 12. The supply curve in Figure 3P-2 shows the monthly market for sweaters at a local craft market. For each of the following events, draw the new outcome. [LO 3.5] a. The price of wool increases. b. Demand for sweaters decreases. c. A particularly cold winter is expected to begin next month. d. Demand for sweaters increases. Answer: A change in the price of a good will cause a movement along the supply curve. A change in a nonprice determinant will cause a shift of the supply curve. a. Point C: This is a change in a nonprice determinant. The supply curve will shift to the left because input prices have increased. b. Point E: A decrease in the demand for sweaters will decrease the price of sweaters, causing a movement down along the supply curve. c. Point B: This is a change in a nonprice determinant. The supply curve will shift to the right because firms expect the demand for sweaters to increase. d. Point D: An increase in the demand for sweaters will increase the price of sweaters, causing a movement up along the supply curve. 13. Refer to the demand and supply schedule shown in Table 3P-3. [LO 3.6] a. If pizza parlors charge $3.50 per slice, will there be excess supply or excess demand? What is the amount of excess supply or excess demand at that price? b. If pizza parlors charge $1.00 per slice, will there be excess supply or excess demand? What is the amount of excess supply or excess demand at that price? c. What are the equilibrium price and quantity in this market? Answer: a. When the price is above the equilibrium price there is an excess supply. In this case, there is an excess supply of 400 slices. b. When the price is below the equilibrium price there is an excess demand. In this case, there is an excess demand of 100 slices. c. The equilibrium price occurs where the quantity demanded equals the quantity supplied, at $1.50. The equilibrium quantity is 200 slices. The graph in Figure 3P-3 shows the weekly market for pizzas in a small town. Use this graph to answer Problems 14–16. 14. Which of the following events will occur at a price of $20? [LO 3.6] a. Equilibrium. b. Excess demand. c. Excess supply. d. No pizzas supplied. e. No pizzas demanded. Answer: There is an excess supply. $20 is above the equilibrium price, which will lead to excess an supply. 15. Which of the following events will occur at a price of $10? [LO 3.6] a. Equilibrium. b. Excess demand. c. Excess supply. d. No pizzas supplied. e. No pizzas demanded. Answer: There is an excess demand. $10 is below the equilibrium price, which will lead to excess demand. 16. What are the equilibrium price and quantity of pizzas? [LO 3.6] Answer: Graphically the equilibrium price and quantity are found at the point where the supply curve intersects the demand curve. At this equilibrium price, the quantity demanded by buyers is equal to the quantity supplied by the sellers and there is no incentive for the sellers to change the price of the good. In other words, there is no excess demand or excess supply for the good. The equilibrium price is $15, and the equilibrium quantity is 150 pizzas. 17. The graph in Figure 3P-4 shows supply and demand in the market for automobiles. For each of the following events, draw the new market outcome, and say whether the equilibrium price and quantity will increase or decrease. [LO 3.7] a. Environmentalists launch a successful One Family, One Car campaign. b. A steel tariff increases the price of steel. c. A baby boom occurred 16 years ago. d. An oil shortage causes the price of gasoline to soar. e. Improvements in robotics increase efficiency and reduce costs. f. The government offers a tax rebate for the purchase of commuter rail tickets. Answer: a. If more families decide to own only one car instead of two or three cars then there is a decrease in the demand for cars. As a result, there will be an excess demand for cars at the existing price and firms will have an incentive to reduce the price of cars. Equilibrium price and quantity will both decrease and the new equilibrium is at point A. b. The increase in the price of steel will increase the cost of producing cars and this will increase the price of cars. The supply curve will shift to the left (a decrease in supply), and the new equilibrium is at point B. The price increases and quantity decreases. c. As these children turn 16 they will learn to drive and some of them will buy cars. The demand for cars will increase and the new equilibrium is at point C. Price increases and quantity increases. d. An increase in the price of gas will make driving more expensive and this will decrease the demand for cars. The new equilibrium is at point A: price decreases and quantity decreases. e. If the cost of production falls, then firms are willing to sell cars for a lower price. The supply curve will shift to the right (increase in supply) and equilibrium is at point D. The price decreases and quantity increases. f. A tax rebate on rail tickets will reduce the cost of train travel (a substitute for driving) and this will decrease the demand for cars. The new equilibrium is at point A: the price decreases and quantity decreases. 18. Say whether each of the following changes will increase or decrease the equilibrium price and quantity, or whether the effect cannot be predicted. [LO 3.7] a. Demand increases; supply remains constant. b. Supply increases; demand remains constant. c. Demand decreases; supply remains constant. d. Supply decreases; demand remains constant. e. Demand increases; supply increases. f. Demand decreases; supply decreases. g. Demand increases; supply decreases. h. Demand decreases; supply increases. Answer: In the first four parts, only one curve is shifting, so the impact on equilibrium price and quantity can be predicted. In the last four parts, two changes are occurring at the same time, so the impact on either equilibrium price or quantity cannot be predicted. Consider a simultaneous increase in demand and increase in supply. The increase in demand will increase equilibrium price and quantity. The increase in supply will decrease equilibrium price and increase equilibrium quantity. Both changes lead to an increase in equilibrium quantity, so this can be predicted. The two changes have opposite impacts on equilibrium price, so this cannot be predicted. a. The equilibrium price increases, and the equilibrium quantity increases. b. The equilibrium price decreases, and the equilibrium quantity increases. c. The equilibrium price decreases, and the equilibrium quantity decreases. d. The equilibrium price increases, and the equilibrium quantity decreases. e. The equilibrium price cannot be predicted, and the equilibrium quantity increases. f. The equilibrium price cannot be predicted, and the equilibrium quantity decreases. g. The equilibrium price increases, and the equilibrium quantity cannot be predicted. h. The equilibrium price decreases, and the equilibrium quantity cannot be predicted. Solution Manual for Macroeconomics Dean Karlan, Jonathan Morduch 9781259813436