This Document Contains Chapters 1 to 3 CHAPTER 1 Modern Principles of Economics: The Big Ideas Facts and Tools 1. A headline in the New York Times read: “Study Finds Enrollment Is Up at Colleges Despite Recession.” How would you rewrite this headline now that you understand the idea of opportunity cost? Solution 1. The easiest change is to switch “despite” to “because of.” Ordinary people focus on the fact that when times are tough, people can’t afford college. Economists, on the other hand, see that there is an opposing effect: when times are tough the price (or opportunity cost) of attending college is low. There’s some truth to both viewpoints. It’s tough for you or your parents to pay for tuition when jobs are hard to come by and income is low, but, as you learned, in the real world it’s actually quite common for students to flood col¬leges during recessions. That means that the price effect usually dominates. 2. When bad weather in India destroys the crop, does this sound like a fall in the total “supply” of crops or a fall in people’s “demand” for crops? Keep your answer in mind as you learn about economic booms and busts later on. Solution 2. It sounds like a fall in supply. 3. How much did national output fall during the Great Depression? According to the chapter, which government agency might have helped to avoid much of the Great Depression had it acted more quickly and appropriately? Solution 3. Output fell by about 30 percent and much of the blame belongs to the Federal Reserve for failing to act. 4. The chapter lists four things that entrepreneurs save and invest in. Which of the four are actual objects, and which are more intangible, like concepts or ideas or plans? Feel free to use Wikipedia or some other reference source to get definitions of un¬familiar terms. Solution 4. Physical capital is the object, while human capital (education), innovation, and efficient organization are more like concepts, ideas, or plans. 5. Who has a better incentive to work long hours in a laboratory researching new cures for diseases: a scientist who earns a percentage of the profits from any new medicine she might invent, or a scientist who will get a handshake and a thank you note from her boss if she invents a new medicine? Solution 5. The scientist who gets a share of the profits will have a stronger incentive to invent more new drugs. 6. In the discussion of Big Idea Five, the chapter says that “self-sufficiency is death” because most of us would not be able to produce for ourselves the food and shelter that we need to survive. In addition to death, however, one could also say that self-sufficiency is boredom or ignorance. How does specialization and trade help you to avoid boredom and ignorance? Solution 6. Just as each of us could not produce enough food and shelter to survive, we also could not produce enough entertainment or educational/informational services to keep us from boredom or ignorance. Under total self-sufficiency, one would have to produce any TV show one watched, and gather any news one is interested in, and so on. Clearly, this is not possible, especially because everyone would be too busy just try¬ing to survive. Thinking and Problem Solving 7. In recent years, Zimbabwe has had hyperinflation, with prices tripling (or more!) every month. According to what you learned in this chapter, what do you think the government can do to end this hyperinflation? Solution 7. It can stop printing so much money. 8. Some people worry that machines will take jobs away from people, making people permanently unemployed. Only 150 years ago in the United States, most people were farmers. Now, machines do almost all of the farm work and fewer than 2% of Americans are farmers, yet that 2% produces enough food to feed the entire country while still exporting food overseas. a. What happened to all of those people who used to work on farms? Do you think most adult males in the U.S. are unemployed nowadays, now that the farm work is gone? b. Some people say that it’s okay for machines to take jobs, because we’ll get jobs fixing the machines. Just from looking around, do you think that most working Americans are earning a living by fixing farm equipment? If not, what do you think most working people are doing instead? (We’ll give a full answer later in this book.) Solution 8. a. They are mostly employed in other industries. Farm states don’t have tens of millions of people searching for jobs. b. Very few people fix farm equipment for a living. Instead, they work in offices, warehouses, and factories. The demand for more goods and services is almost limitless so when innovations make it possible to produce a good with fewer resources, other resources (including labor) are freed up to produce other goods. 9. Let’s connect Big Ideas Six and Nine: Do you think that people in poor countries are poor because they don’t have enough money? In other words, could a country get richer by printing more pieces of paper called “money” and handing those out to its citizens? Solution 9. No. If a country printed more money, prices would rise, but the country would not get richer. 10. Nobel Prize winner Milton Friedman said that a bad central banker is like a “fool in the shower.” In a shower, of course, when you turn the faucet right now, it won’t show up in the showerhead for a few seconds. So if a “fool in the shower” is always making big changes in the temperature based on how the water feels right now, the water is likely to swing back and forth between too hot and too cold. How does this apply to central banking? Solution 10. It takes a few months for the central banker’s actions to affect the economy. So if he or she is always making today’s decisions based on how the economy looks right now, he or she might make the economy swing back and forth between too “hot” and too “cold.” 11. According to the United Nations, there were roughly 300 million humans on the planet a thousand years ago. Essentially all of them were poor by modern standards: They lacked antibiotics, almost all lacked indoor plumbing, and none traveled faster than a horse or a river could carry them. Today, between 1 and 3 billion humans are poor out of about 7 billion total humans. So, over the last thousand years, what has happened to the fraction of humans who are poor: Did it rise, fall, or stay about the same? What happened to the total number of people living in deep poverty: Rise, fall, or no change? Solution 11. The fraction of poor people has fallen: almost 100 percent were poor in 1000 AD, while much less than 50 percent are poor now. The number of poor has risen: We went from about 300 million poor people to 1 to 3 billion today, depending on your definition of poverty. The number of poor people has increased, partly because fewer poor people starve to death today than in the past; in this sense today’s poor are marginally better off than the poor of the past. Challenges 12. We claim that part of the reason the Great Depression was so destructive is because economists didn’t understand how to use government policy very well in the 1930s. In your opinion, do you think that economists during the Great Depression would have agreed? In other words, if you had asked them why the Depression was so bad, would they have said, “Because the government ignored our wise advice,” or would they have said, “Because we don’t have any good ideas about how to fix this?” What does your answer tell you about the confidence of economists and other experts? Solution 12. They probably would have been very confident. That’s what experts tend to do: Project confidence even when they aren’t entirely sure. Today, most economists think that the Great Depression could have been avoided. Even if they are right, that doesn’t mean that economists today know enough to avoid future depressions, since many things have changed since the 1930s. Economic knowledge and the economy both continue to grow. 13. Some problems that economists try to solve are easy as economic problems but hard as political problems. Medical doctors face similar kinds of situations: Preventing most deaths from obesity or lung cancer is easy as a medical problem (eat less, exercise more, don’t smoke), but hard as a self-control problem. With this in mind, how is ending hyperinflation like losing 100 pounds? Solution 13. Losing 100 pounds requires a lot of self-control. Similarly, ending hyperinflation requires a lot of self-control: The government must stop using the printing press to pay for things. 14. As Nobel prize winner and New York Times columnist Paul Krugman has noted, the field of economics is a lot like the field of medicine: They are fields where knowledge is limited (both are new as real scientific disciplines), and where many cures are quite painful (opportunity cost), but where regular people care deeply about the issues. What are some other ways that economics and medicine are alike? Solution 14. There are many possible answers, but one possible one is that it’s hard in both fields to run good experiments: When people are sick or economies are in trouble, you want to help them, but you can’t just say, “No, we’re going to help half of the economies the best we can and leave the others alone.” Both fields have a lot of phonies, snake-oil salespeople, and amateurs who offer their very-confident opinions about how to fix things. And, the person-on-the-street often has strong opinions about both fields—They are often more confident than the experts. On the other hand, hopefully, they are both fields that we will know a lot more about in the future! 15. Economics is sometimes called “the dismal science.” Of the Big Ideas in this chapter, which sound dismal—like bad news? Solution 15. These are often a matter of judgment (as are many of the Challenge questions). Here are the most obvious examples: 1. Big Idea Three, that trade-offs are everywhere. 2. Big Idea Eight, that you have to live with the boom–bust cycle. 3. Big Idea Ten, that central banking is hard, so even the best might fail. CHAPTER 2 Modern Principles of Economics: The Power of Trade and Comparative Advantage Facts and Tools 1. Use the idea of the “division of knowledge” to answer the following questions. a. Which country has more knowledge: Utopia, where in the words of Karl Marx, each person knows just enough about hunting, fishing, and cattle raising to “hunt in the morning, fish in the afternoon, [and] rear cattle in the evening,” or Drudgia, where one-third of the population learns only about hunting, one-third only about fishing, and one-third only about cattle raising? b. Which planet has more knowledge: Xeroxia, each of whose one million inhabit¬ants knows the same list of one million facts, or Differentia, whose one million inhabitants each know a different set of one million facts? How many facts are known in Xeroxia? How many facts are known in Differentia? Solution 1. a. There is more knowledge in Drudgia. b. In Xeroxia, people know one million facts. In Differentia, people know one trillion facts, a million times more. We would expect Differentia to have a higher standard of living. 2. In the Wealth of Nations, Adam Smith said that one reason specialization makes someone more productive is because “a man commonly saunters a little in turning his hand from one sort of employment to another.” How can you use this observation to improve your pattern of studying for your four or five college courses this semester? Solution 2. You should set aside long blocks of time (perhaps 1 to 2 hours) for each individual course, rather than switching every 15 minutes from reading biology to reading economics and back again. Every time you switch jobs, you waste some time getting used to the new task. 3. “Opportunity cost” is one of the tougher ideas in economics. Let’s make it easier by starting with some simple examples. In the following examples, find the opportunity cost: Your answer should be a rate, as in “1.5 widgets per year” or “6 lectures per month.” Ignoring Adam Smith’s insight from the previous question, assume that these relationships are simple linear ones, so that if you put in twice the time you get twice the output, and half the time yields half the output. a. Erin has a choice between two activities: She can repair one transmission per hour or she can repair two fuel injectors per hour. What is the opportunity cost of repairing one transmission? b. Katie works at a customer service center and every hour she has a choice between two activities: answering 200 telephone calls per hour or responding to 400 emails per hour. What is the opportunity cost of responding to 400 phone calls? c. Deirdre has a choice between writing one more book this year or five more articles this year. What is the opportunity cost of writing half a book this year, in terms of articles? Solution 3. a. 2 fuel injectors. b. 800 emails. c. 2.5 articles. 4. a. American workers are commonly paid much more than Chinese workers. True or false: This is largely because American workers are typically more productive than Chinese workers. b. Julia Child, an American chef (and World War II spy) who reintroduced French cooking to Americans in the 1960s, was paid much more than most American chefs. True or false: This was largely because Julia Child was much more productive than most American chefs. Solution 4. a. True. Productivity differences are the biggest reason for wage differences. b. True. Although Julia Child could not cook a 3-minute egg any faster than any other chef, her valuable output included her television show and many cook¬books. Thus, as a celebrity chef and cookbook author, Julia Child produced much more GDP than the typical restaurant chef and was more productive. 5. According to the Wall Street Journal (August 30, 2007, “In the Balance”), it takes about 30 hours to assemble a vehicle in the United States. Let’s use that fact plus a few invented numbers to sum up the global division of labor in auto manufactur¬ing. In international economics, “North” is shorthand for the high-tech developed countries of East Asia, North America, and Western Europe, while “South” is short-hand for the rest of the world. Let’s use that shorthand here. a. Consider the following productivity table: Which region has an absolute advan¬tage at making high-quality cars? And low-quality cars? b. Using the information in the productivity table, estimate the opportunity cost of making high- or low-quality cars in the North and in the South. Which region has a comparative advantage (i.e., lowest opportunity cost) for manufacturing high-quality cars? For low-quality cars? c. One million hours of labor are available for making cars in the North, and another 1 million hours of labor are available for making cars in the South In a no-trade world, let’s assume that two-thirds of the auto industry labor in each region is used to make high-quality cars and one-third is used to make low-quality cars. Solve for how many of each kind of car will be produced in North and South, and add up to determine total global output of each type of car. (Why will both kinds of cars be made? Because the low-quality cars will be less expensive.) d. Now allow specialization. If each region completely specializes in the type of car in which it holds the comparative advantage, what will global output of high-quality cars be? Of low-quality cars? In the following table, report your answers. Is global output in each kind of car higher than before? (We’ll solve a problem with the final step of trade in the Thinking and Problem Solving section.) Solution 5. a. North has an absolute advantage at both high-quality and low-quality cars. b. After calculating opportunity costs horizontally within countries, compare them vertically across countries to determine who has a comparative advantage. North’s comparative advantage is high-quality cars (lower opportunity cost of making high-quality cars). South’s comparative advantage is low-quality cars (lower opportunity cost of making low-quality cars). c. Output with no trade. d. Given this setup, the number of high-quality cars is identical with specialization and the number of low-quality cars increases: 6. It has been reported that John Lennon was once asked whether Ringo was the best drummer in the world, and he quipped, “He’s not even the best drummer in the Beatles!” (Paul also drummed on some of the White Album.) Assuming that this story is true and that Lennon was correct, explain, using economics, why it could still make sense to have Ringo on drums. Solution 6. Even if Paul were a better drummer than Ringo, Ringo could have a comparative advantage in drumming. If Paul was a little bit better than Ringo on drums and much better than Ringo at playing bass and singing (surely true), then the total output of The Beatles could be increased by not having the best drummer on drums. Thinking and Problem Solving 7. Fit each of the following examples into one of these reasons for trade: I. Division of knowledge II. Comparative advantage a. Two recently abandoned cats, Bingo and Tuppy, need to quickly learn how to catch mice in order to survive. If they also remain well groomed, they stand a better chance of surviving: Good grooming reduces the risk of disease and para¬sites. Each cat could go it alone, focusing almost exclusively on learning to catch mice. The alternative would be for Bingo to specialize in learning how to groom well and for Tuppy to specialize in learning how to catch mice well. b. Supreme Court Chief Justice John Roberts hires attorneys who are less skilled than himself to do routine legal work. Solution 7. a. Division of knowledge b. Comparative advantage 8. Nobel Laureate Paul Samuelson said that comparative advantage is one of the few ideas in economics that is both “true and not obvious.” Since it’s not obvious, we should practice with it a bit. In each of the cases, who has the absolute advan¬tage at each task, and who has the comparative advantage? a. In 30 minutes, Kana can either make miso soup or she can clean the kitchen. In 15 minutes, Mitchell can make miso soup; it takes Mitchell an hour to clean the kitchen. b. In one hour, Ethan can bake 20 cookies or lay the drywall for two rooms. In one hour, Sienna can bake 100 cookies or lay the drywall for three rooms. c. Kara can build two glass sculptures per day or she can design two full-page newspaper advertisements per day. Sara can build one glass sculpture per day or design four full-page newspaper ads per day. d. Data can write 12 excellent poems per day or solve 100 difficult physics problems per day. Riker can write one excellent poem per day or solve 0.5 difficult physics problems per day. Solution 8. a. Mitchell’s absolute and comparative advantages are at miso; Kana’s absolute and comparative advantages are at cleaning. b. Sienna has an absolute advantage at both, but her comparative advantage is at baking cookies. Ethan’s comparative advantage is at laying drywall. c. Kara’s absolute and comparative advantages are at sculpture, while Sara’s absolute and comparative advantages are at newspaper ad design. d. Data has an absolute advantage at both, but Riker has a comparative advantage at writing poetry. 9. The federal education reform law known as No Child Left Behind requires every state to create standardized tests that measure whether students have mastered key subjects. Since the same test is given to all students in the same grade in the state, this encourages all schools within a state to cover the same material. According to the division of knowledge model, what are the costs of this approach? Solution 9. The cost is that with everyone knowing the same thing, our “hive mind,” our social knowledge, is less powerful than it could be. For instance, some parts of a state might emphasize statistics courses in high school while other parts might emphasize geometry and other parts might emphasize number theory. Each could be useful at a particular place and time, but few students would have the time to master all three fields. But it’s not necessary for everyone to master all three: It’s enough to have a few (thousand) people who master each field, just in case a need arises. Undergraduate university education is more specialized than high school, graduate university education is more specialized yet. Indeed, the ideal of a graduate education is that at some point the PhD candidate knows something that no one else in the world knows! 10. In this chapter, we’ve often emphasized how specialization and exchange can create more output. But sometimes the output from voluntary exchange is difficult to mea¬sure and doesn’t show up in GDP statistics. In each of the following cases, explain how the two parties involved might be able to make themselves both better off just by making a voluntary exchange. a. Alan received two copies of Gears of War as birthday gifts. Burton received two copies of Halo as birthday gifts. b. Jeb has a free subscription to Field and Stream but isn’t interested in hunting. George has a free subscription to the Miami Herald but isn’t all that interested in Florida news. c. Pat has a lot of love to give, but it is worthless unless received by another. Terry is in the same sad situation. Solution 10. a. Alan could give one of his copies of Gears to Burton, who could offer one of his copies of Halo to Alan. b. They could swap free subscriptions and both be better off, especially if both men have the last name Bush. At the very least, both parties are no worse off after the exchange. c. If they offer love to each other, both will be better off at no cost—a classic positive-sum game. 11. Many people talk about manufacturing jobs leaving the United States and going to other places, like China. Why isn’t it possible for all jobs to leave the United States and go overseas (as some people fear)? Solution 11. This is not possible because every nation has to have a comparative advantage in something. The greater China’s comparative advantage in manufacturing, for example, the greater the United States’ comparative advantage must be in some other type of production. (This can be seen in Table 2.1: The numbers in each row are just reciprocals, so the lower the opportunity cost of a shirt in Mexico, the greater the opportunity cost of a computer in Mexico.) The more that firms want to locate manufacturing processes in countries like China, the more that those countries would give up (the higher the opportunity cost) if they pursued other, nonmanufacturing activities. Even if it were cheaper to produce everything in China—thus giving China something like an absolute advantage in all production—trade is based on comparative advantage, not absolute advantage. 12. Suppose the following table shows the number of labor hours needed to produce airplanes and automobiles in the United States and South Korea, but one of the numbers is unknown. a. Without knowing the number of labor hours required to produce an auto in South Korea, you can’t figure out which country has the comparative advantage in which good. Can you give an example of a number for the empty cell of the table that would give the United States the comparative advantage in the production of airplanes? What about South Korea? b. Who has the absolute advantage in the production of airplanes? What about autos? c. What exact number would you have to place in the empty cell of the table for it to be impossible that trade between the United States and South Korea could benefit both nations? Solution 12. a. Any number less than 12.5 will give the United States the comparative advantage in airplanes. Any number higher than 12.5 will give South Korea the comparative advantage in airplanes. b. The United States clearly has the absolute advantage in the production of airplanes. We do not know who has the absolute advantage in the production of autos. If the missing number is greater than 5, the United States has the absolute advantage in autos; if the missing number is less than 5, South Korea has the absolute advantage. c. If the missing number was exactly equal to 12.5, then the opportunity cost of one airplane would be 160 autos in both countries. In this case, no possible benefits exist from trade, because neither country can produce either good at a lower cost than can the other country. 13. In the chapter, you saw how to create a production possibilities frontier for the United States and Mexico. Let’s take a look at how to combine these PPFs to make one PPF for the U.S.–Mexico trade alliance. You’ll use the same set of axes that was used in the chapter: computers on the vertical axis and shirts on the horizontal axis. Refer to Figure 2.1 and Table 2.1 as needed. a. First, you need to plot the endpoints of the PPF by figuring out the maximum numbers of computers and shirts. If both the United States and Mexico produced only computers, how many would they produce? What if they only produced shirts? Plot these two points and label them as A (all computers) and Z (all shirts). The PPF for the U.S.–Mexico trade alliance is going to look a little different from the PPFs for the individual countries, so we don’t want to simply connect the two points with a straight line. We need to figure out the rate at which the U.S.–Mexico trade alliance gives up computers to get shirts (or vice versa). b. Starting at point A, if citizens of the United States or Mexico decided they wanted more shirts, where would those shirts be produced? Why? What do you think the PPF should look like as the U.S.–Mexico trade alliance initially moves away from point A? c. Starting at point Z, if citizens of the United States or Mexico decided they wanted more computers, where would those computers be produced? Why? What do you think the PPF should look like as the U.S.–Mexico trade alliance initially moves away from point Z? d. Plot the point at which each country is completely specializing in the good for which it has the comparative advantage. Label this point B. Connect points A, B, and Z. This is the PPF for the U.S.–Mexico trade alliance. Can you describe how this PPF is a combination of the two nations’ separate PPFs? e. Suppose now that a third nation, Haiti, enters the trade alliance. In Haiti, the opportunity cost of a computer is 12 shirts, and Haiti has the labor necessary to produce 1 computer (or 12 shirts). Can you draw a new PPF for the U.S.–Mexico–Haiti trade alliance? f. Okay, what will happen to the PPF as more and more countries join the trade alliance? What would it look like with an infinite number of countries? Solution 13. The United States could produce 24 computers or 24 shirts. Mexico could produce two computers or 12 shirts. a. If both countries devote all of their resources to producing computers, they could produce 26 computers (24 + 2). Point A should be placed at the point (0, 26). If both countries devote all of their resources to producing shirts, they could produce 36 shirts (24 + 12). Point Z should be placed at the point (36, 0). b. The United States has an opportunity cost of one computer per shirt. In Mexico, one shirt carries an opportunity cost of (2/12) = (1/6) computer. Mexico has the lower opportunity cost of producing shirts, so it should be the first to reduce computer production in order to produce shirts. c. The United States has an opportunity cost of one shirt per computer and Mexico has the opportunity cost of 6 shirts per computer. The United States has the lower opportunity cost of producing computers, and so would be the first to reduce shirt production in order to produce computers. d. If Mexico produces only shirts and the United States produces only computers, their combined output would be 12 shirts and 24 computers. Point B should be placed at (12, 24). e. and f. See the PPF for the U.S.–Mexico–Haiti trade alliance in the figure above. When we add a country to the World PPF, the frontier shifts out but it also tends to become more concave, or bounded out. Mexico was a lower-cost producer of shirts than the United States, which is why the first part of the World PPF starting from 0 shirts has a lower, or flatter, slope. Haiti has an even lower cost of producing shirts than Mexico, so when we add Haiti, the initial slope starting from 0 shirts is even flatter—which means that we can have more shirts and give up fewer computers. In the same way, when we add countries that are even more productive at producing computers (i.e., a high cost of producing shirts) than the United States, the PPF gets steeper (starting from zero computers on the horizontal axis). Therefore, we can get lots of computers just by giving up a few shirts. In other words, by allocating production first to where it can be done at the lowest cost, countries can increase the total amount produced beyond the sum of each country’s individual production, which is another way of expressing comparative advantage and the gains from trade. Challenges 14. In the computers and shirts example from the chapter, the United States traded one computer to Mexico in exchange for three shirts. This is not just an arbitrary ratio of shirts to computers, however. Let’s explore the terms of trade a little bit more. a. Why is trading away a computer for three shirts a good trade for the United States? Why is it also a good deal for Mexico? b. What if, instead, the agreed-upon terms of trade were one computer for eight shirts? Would this trade still benefit both the United States and Mexico? c. What is the maximum (and minimum) number of shirts that a computer can trade for if the United States and Mexico are both to benefit from the trade? Solution 14. a. This is a good deal for the United States, because it only gave up one shirt to produce the computer, so receiving three shirts benefits the United States. It is a good deal for Mexico because Mexico would have to give up six shirts to produce one computer on its own, so if Mexico can gain one computer by giving up only three shirts, this deal makes that country better off. b. This trade would benefit the United States, since it will still be receiving more shirts (eight) than it gave up in order to produce the computer (one). However, this would not benefit Mexico because Mexico could have produced its own computer at an opportunity cost of just eight shirts, which would be a better deal than trading at this rate. c. The number of shirts traded for each computer must be higher than one so that it benefits the United States but less than six so that it benefits Mexico. 15. Go to www.Ted.com and watch Thomas Thwaites’s talk, “How I built a toaster—from scratch.” How much money and time do you think Thwaites spent building his toaster? How long do you think it would have taken Thwaites to earn enough money in, say, a mini¬mum wage job to buy a toaster? Comment on the division of labor and the importance of specialization in increasing productivity. Solution 15. Thwaites seems to have spent several thousand dollars and about a year to “build” his toaster, which probably would have killed him had he tried to plug it in. If he had gone to Walmart, Thwaites could have bought a toaster for about $15 or two hours of work at the minimum wage. In other words, the division of labor and specialization meant that Thwaites’ productivity was multiplied by a factor of at least one thousand. Due to the power of specialization and comparative advantage, Thwaites and you and I are able purchase goods that we could not have produced on our own without much, much greater effort and expense if at all. CHAPTER 3 Modern Principles of Economics: Supply and Demand Facts and Tools 1. When the price of a good increases, the quantity demanded ____. When the price of a good decreases, the quantity demanded ____. Solution 1. When the price of a good increases, the quantity demanded falls. When the price of a good decreases, the quantity demanded rises. 2. When will people search harder for substitutes for oil: When the price of oil is high or when the price of oil is low? Solution 2. When the price of oil is high, people will search harder for substitutes. 3. Your roommate just bought a Nike+ Sportwatch for $160. She would have been willing to pay $250 for a device that could improve her morning runs by measuring the speed, distance, and duration of the runs, and calculating the calories she burns. How much consumer surplus does your roommate enjoy from the Nike+ Sport¬watch? Solution 3. Your roommate enjoys $90 of consumer surplus from the Nike+ Sportwatch (willing¬ness to pay minus price you actually paid equals consumer surplus: $250 − $160 = $90). 4. What are three things that you’ll buy less of once you graduate from college and get a good job? What kinds of goods are these called? Solution 4. There are many possible answers, including ramen noodles, macaroni and cheese, clothes from discount stores, low-quality used cars, and bus tickets. These are called “inferior goods.” 5. When the price of Apple MacBooks goes down, what probably happens to the computers? Solution 5. The demand for laptops featuring Microsoft Windows probably falls—remember that this means the entire demand curve shifts down and to the left. The demand for laptops featuring Microsoft Windows falls when the price of MacBooks goes down because laptops featuring Microsoft Windows and MacBooks are substitutes. Thus, when the price of MacBooks goes down, people switch to buying more MacBooks and fewer laptops that feature Microsoft Windows at any particular price. 6. a. When the price of olive oil goes up, what probably happens to the demand for corn oil? b. When the price of petroleum goes up, what probably happens to the demand for natural gas? To the demand for coal? To the demand for solar power? Solution 6. a. The demand for corn oil probably goes up—remember that this price increase means the entire demand curve shifts up and to the right, and that the demand for corn oil rises when the price of olive oil goes up because olive oil and corn oil are substitutes. b. When the price of petroleum goes up, the demand for these substitutes also goes up. 7. a. If everyone thinks that the price of tomatoes will go up next week, what is likely to happen to demand for tomatoes today? b. If everyone thinks that the price of gasoline will go up next week, what is likely to happen to the demand for gasoline today? (Note: Is this change in demand caused by consumers or by gas station owners?) Solution 7. a. Today’s demand for tomatoes will probably rise, since people see “tomatoes today” and “tomatoes next week” as substitutes. b. It’s the same question as 7a: So gas demand probably rises. This rise in demand is caused by consumers, since consumers create demand, not the gas station owners. 8. Along a supply curve, if the price of oil falls, what will happen to the quantity of oil supplied? Why? Solution 8. As the price of oil falls, it will drop below the cost of production of the highest-cost producers, such as those developing Canada’s tar sands. Thus, as the price falls, the high-cost producers will stop producing, thereby reducing the quantity supplied. 9. If the price of cars falls, are carmakers likely to make more or fewer cars, according to the supply curve? (Notice that the “person on the street” often thinks the opposite is true!) Solution 9. If the price of cars falls but the technology for making cars stays the same, carmakers are likely to produce fewer cars. This is because at a lower price, the only factories that will stay open are the ones that are most efficient at producing cars. The person on the street often thinks that if the price falls, businesses will have to make more cars in order to earn the same amount of total revenue, but this logic is wrong in most cases. Rational business owners care about profits (total revenue minus costs) not total revenue. 10. When is a pharmaceutical business more likely to hire highly educated, cutting-edge workers and use new, experimental research methods: When the business expects the price of its new drug to be low or when it expects the price to be high? Solution 10. A pharmaceutical business will invest more in research, including hiring the very best researchers, when they expect new drug prices to be higher. 11. Imagine that a technological innovation reduces the costs of producing high-quality steel. What happens to the supply curve for steel? Solution 11. The supply of steel will increase. Lower costs shift the supply curve down and to the right. 12. When oil companies expect the price of oil to be higher next year, what happens to the supply of oil today? Solution 12. When they expect the price to rise in the future, they cut supply today. “Oil now” and “oil next year” are substitutes in production so when the price of oil is expected to be high next year, firms will devote fewer resources to producing oil this year and more to producing oil next year. 13. Do taxes usually increase the supply of a good or reduce the supply? Solution 13. To a firm, taxes are equivalent to higher costs, which shifts the supply curve up and to the left. In other words, higher taxes cause supply to fall. Thinking and Problem Solving 14. Consider the following supply curve for oil. Note that MBD stands for “millions of barrels per day,” the usual way people talk about the supply of oil: a. Based on this supply curve, fill in the table: b. If the price for a barrel of oil was $15, how much oil would oil suppliers be willing to supply? c. What is the lowest price at which suppliers of oil would be willing to supply 20 MBD? Solution 14. a. b. 25 MBD c. $12 per barrel 15. From the following table of prices per 100 pencils and quantities supplied (in hundreds of pencils), draw the supply curve for pencils: Solution 15. 16. Suppose LightBright and Bulbs4You were the only two suppliers of 60-watt lightbulbs in Springfield. Draw the supply curve for the 60-watt lightbulb industry in Springfield from the following tables for the two companies. To create this “light bulb industry supply curve,” note that you’ll add up the total number of bulbs that the industry will supply at a price of $1 (15 bulbs), and then do the same for the prices of $5, $7, and $10: Solution 16. The key is to look at a certain price, like $5, and add how much would be produced by each firm at that price. 17. Using the following diagram, identify and calculate total producer surplus if the price of oil is $50 per barrel. Recall that for a triangle, area = (1/2) × base × height. (You never thought you’d use that equation unless you became an engineer, did you?) Solution 17. Producer surplus: 0.5(45)(60) = $1,350 18. In Sucrosia, the supply curve for sugar is as follows: Under pressure from nutrition activists, the government decides to tax sugar producers with a $5 tax per 100-pound bag. Using the figure above, draw the new supply curve. After the tax is enacted, what price will bring forth quantities of 10,000? 15,000? 20,000? Give your answers in the table. Solution 18. The new supply curve will be $5 higher than the old one.
Price (per 100 pound bag) Quantity
$35 10,000
$55 15,000
$75 20,000
19. Consider the farmers talked about in the chapter who have land that is suitable for growing both wheat and soybeans. Suppose all farmers are currently farming wheat but the price of soybeans rises dramatically. a. Does the opportunity cost of producing wheat rise or fall? b. Does this shift the supply curve for wheat (as in one of the panels of Figure 3.11), or is it a movement along a fixed supply curve? What direction is this shift or movement? Illustrate your answer on the following figure: Solution 19. a. When the price of soybeans rises, the opportunity cost of growing wheat also rises. When you have a great alternative, that means you have a high opportunity cost of sticking with the same old, same old. b. This reduces the supply of wheat. Higher opportunity costs suggest that some producers will invariably shift to producing soybeans, thereby reducing total wheat supply. 20. Consider the following demand curve for oil: a. Using this demand curve, fill in the following table: b. If the price was $10, how much oil would be demanded? c. What is the maximum price (per barrel) that demanders will pay for 20 million barrels of oil? Solution 20. a. b. 55 MBD c. $25 per barrel 21. From the following chart, draw the demand curve for pencils (in hundreds): Solution 21. 22. If the price of glass dramatically increases, what are we likely to see a lot less of: glass windows or glass bottles? Why? Solution 22. We’ll probably see a big decline in glass bottles, but only a small decline in glass windows. Plastic is a good substitute for glass in the manufacturing of bottles, but not as good a substitute for windows. Thus, we would probably see a greater decline in glass bottles than windows. 23. Let’s think about the demand for LED TVs. a. If the price for a 60-inch LED TV is $800, and Newhart would be willing to pay $3,000, what is Newhart’s consumer surplus? b. Consider the following figure for the total demand for LED TVs. At $800 per TV, 1,200 TVs were demanded. What would be the total consumer surplus? Calculate the total, and identify it on the diagram. c. Where is Newhart in the figure? Solution 23. a. Individual consumer surplus: $2,200 b. Total consumer surplus: $2,520,000: It’s 1/2 × base × height. c. The vertical dashed line at the bottom of the gray triangle below reflects Newhart’s consumer surplus: $2200, which is $3000 – $800. 24. If income increases and the demand for good X shifts as shown in the figure, then is good X a normal or inferior good? Give an example of a good like good X. Solution 24. Inferior. The shift is a fall in demand, and when a rise in income causes a fall in demand, that’s the definition of an “inferior good.” Ramen noodles, secondhand clothes, and Hamburger Helper are all examples of inferior goods for most people in rich countries like the United States. (Note: All of these goods might be normal goods for people living in the world’s poorest countries.) 25. Assume that butter and margarine are substitutes. What will happen to the demand curve for butter if the price of margarine increases? Why? Solution 25. Demand increases, that is, the curve shifts to the right and up. Price of margarine goes up → Less margarine consumed → Increased demand for butter 26. Cars and gasoline are complements. What will happen to the demand curve for gasoline if the price of cars decreases? Why? (Hint: What happens to the quantity of demanded cars?) Solution 26. Price of cars → More consumption of cars → More consumption of gas 27. Suppose that the supply curve for solar panels is as shown in the diagram: The government decides that it would like to increase the quantity of solar panels in use, so it offers a $20 subsidy per panel to producers. Draw the new supply curve. (Hint: Remember our analysis of how a tax affects supply, as shown in Figure 3.12, and bear in mind that a subsidy can be thought of as a “negative tax.”) Solution 27. The $20 subsidy shifts the supply curve down at each point along the curve by exactly $20 so the old and new supply curves look like this: Challenges 28. Jessica is an economist. She loves being an economist so much that she would do it for a living even if she only earned $30,000 per year. Instead, she earns $103,000 per year. (Note: This is the average salary of new economists with a PhD degree.) How much producer surplus does Jessica enjoy? Solution 28. She enjoys $73,000 of producer surplus. 29. The economist Bryan Caplan recently found a pair of $10 arch supports that saved him from the pain of major foot surgery. As he stated on his blog (econlog.econ¬lib.org), he would have been willing to pay $100,000 to fix his foot problem, but instead he paid only a few dollars. a. How much consumer surplus did Bryan enjoy from this purchase? b. If the sales tax was 5 percent on this product, how much revenue did the government raise when Bryan bought his arch supports? c. If the government could have taxed Bryan based on his willingness to pay rather than on how much he actually paid, how much sales tax would Bryan have had to pay? Solution 29. a. $99,990 b. 50 cents c. $5,000 30. For most young people, working full time and going to school are substitutes: You tend to do one or the other. When it’s tough to find a job, does that raise the opportunity cost of going to college or does it lower it? When it’s tough to find a job, does the demand for college rise or fall? Solution 30. When it’s tough to find a job, the opportunity cost of going to college is lower. The demand for college typically rises as a result. 31. What should happen to the “demand for speed” (measured by the average speed on highways) once airbags are included on cars? Solution 31. Airbags decrease the costs associated with driving fast by decreasing injuries caused by high-speed crashes; the demand for speed thus increases, raising the average speed. As a result, safety devices such as airbags and mandatory seatbelt use tend to increase the safety of car drivers and passengers (although not as much as if there were no increase in speed), but they decrease the safety of pedestrians. 32. The industrial areas in northeast Washington, D.C., were relatively dangerous in the 1980s. Over the last two decades, the area has become a safer place to work (although there are still seven times more violent crimes per person in these areas compared with another DC neighborhood, Georgetown). When an area becomes a safer place to work, what probably happens to the “supply of labor” in that area? Solution 32. A decrease in crime reduces the costs of supplying labor in crime-prone neighborhoods; the supply curve for labor thus shifts down and to the right, i.e., there is an increase in labor supply. 33. The Federal Reserve Economic Data (FRED) database is available at https://fred.stlouisfed.org/. Go to FRED and search for data on crude oil prices. You will find several series; click on one of them, such as the Global price of WTI Crude. Adjust the dates to focus in on the 2006–2010 period. The 2008–2009 recessions is shown by the shaded area. a. Print the graph. b. What happened to crude oil prices during the recession, especially as the recession continued? c. Do you think the change in price was driven more by a shift to demand or to supply? Using the lists of important demand and supply shifters from Chapter 3, what was the major factor shifting demand or supply? d. Draw a demand and supply curve diagram. Label the initial price the “pre-recession price.” Show the new demand or supply curve. Label the new price the “recession price.” e. FRED has several series for the oil price. Why doesn’t it matter which one we use? Solution 33. a. b. Crude oil prices were rising before the recession, but they fell quickly as the recession continued. c. We would need an increase in supply to push prices down. The technology of oil production doesn’t change very rapidly, however, so it’s more likely that the fall in price was caused by a reduction in demand. The major factor reducing demand would be a fall in income. As incomes fell, the demand for oil fell, causing a reduction in the price of oil. d. e. Oil is a relatively homogenous good and the price of oil is set on world markets, so whether it’s West Texas oil or Saudi Arabian oil the price is similar everywhere. Solution Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766
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