This Document Contains Chapters 7 to 8 CHAPTER 7 Modern Principles of Economics: The Price System: Signals, Speculation, and Prediction Facts and Tools 1. a. Suppose you’d like to do five different things, each of which requires exactly one orange. Complete the following table, ranking your highest-valued orange-related activity (1) to your lowest-valued activity (5). b. Suppose the price per orange is high enough that you buy only four. What activity do you not do? c. How low would the price of oranges have to fall for you to purchase five or¬anges? What does the price at which you would just purchase the fifth orange tell us about the value you receive from the fifth-ranked activity? Solution 1. a. Any order is fine, though watch out for the student that prioritizes throwing the orange at someone they don’t like. b. Whatever activity the student ranked at number 5. c. The price at which the student would just purchase the fifth orange is the value (or just slightly below the value) of the fifth-ranked activity. 2. The supply and demand for copper change constantly. New sources are discovered, mines collapse, workers go on strike, products that use it wane in and out of popu¬larity, weather affects shipping conditions, and so on. a. Suppose you learned that growing political instability in Chile (the largest pro¬ducer of copper) will greatly reduce the productivity of its mines in two years. Ignoring all other factors, which curve (demand or supply) will shift which way in the market for copper two years from now? b. Will the price rise or fall as a result of this curve shift? c. Given your answer in part b, would a reasonable person buy copper to store for later? Why or why not? Ignore storage costs. d. As a result of many people imitating your choice in part c, what happens to the current price of copper? e. Does the action in parts c and d encourage people to use more copper today or less copper today? Solution 2. a. Supply would decrease, that is, it will shift to the left (up). b. The price will rise. c. A reasonable person would buy and store copper now if the price was going to rise in the future. d. The current price would be higher. e. The high price encourages people to begin to conserve copper today. 3. In this chapter, we noted that successful economies are more likely to have many failing firms. If a nation’s government instead made it impossible for inefficient firms to fail by giving them loans, cash grants, and other bailouts to stay in business, why is that nation likely to be poor? (Hint: Steven Davis and John Haltiwanger. 1999. “Gross Job Flows.” In Handbook of Labor Economics, [Amsterdam: North–Holland] found that in the United States, 60% of the increase in U.S. manufacturing efficiency was caused by people moving from weak firms to strong firms.) Solution 3. If the most inefficient firms are kept from failing, then many people are spending their days producing less than they would at a more efficient firm. Less production implies that, on average, people will have less to consume. Thus, the country produces less output for any given level of investment of resources. 4. For you, personally, what is your opportunity cost of doing this homework? Solution 4. Any activity the student could reasonably be doing in place of doing homework and is believable as their next-best option would be appropriate, for example, watching a movie. 5. Suppose you are bidding on a used car and someone else bids above the highest amount that you are willing to pay. What can you say for sure about that person’s monetary value of the good compared to yours? Solution 5. That person’s monetary value of the used car is higher than yours. 6. Sometimes speculators get it wrong. In the months before the Persian Gulf War, speculators drove up the price of oil: The average price in October 1990 was $36 per barrel, more than double its price in 1988. Oil speculators, like many people around the world, expected the Gulf War to last for months, disrupting the oil supply throughout the Gulf region. Thus, speculators either bought oil on the open market (almost always at the high speculative price) or they already owned oil and just kept it in storage. Either way, their plan was the same: to sell it in the future, when prices might even be higher. As it turned out, the war was swift: After one month of massive aerial bombard¬ment of Iraqi troops and a 100-hour ground war, then-President George H. W. Bush declared a cessation of hostilities. Despite the fact that Saddam Hussein set fire to many of Kuwait’s oil fields, the price of oil plummeted to about $20 per barrel, a price at which it remained for years. a. Is buying oil for $36 a barrel and selling it for $20 per barrel a good business plan? How much profit did speculators earn, or how much money did they lose, on each barrel? b. Why did the speculators follow this plan? c. When the speculators sold their stored oil in the months after the war, did this massive resale tend to increase the price of oil or decrease it? d. Do you think that many consumers complained about speculators or even realized that speculators were influencing the price of oil in spring 1991? Solution 6. a. This is obviously a bad business plan. Speculators lost $16 on each barrel. b. Speculators did this because they thought the price would stay high. They believed in their hunch strongly enough to bet their own money on it. c. This increase in supply reduced the price of oil after the war. d. Few consumers thought about the speculators, even though by betting wrong the speculators reduced social surplus. Oddly, it’s when speculators bet right and increase social surplus that they are more often attacked! 7. You manage a department store in Florida, and one winter day you read in the newspaper that orange juice futures have fallen dramatically in price. Should your store stock up on more sweaters than usual, or should your store stock up on more Bermuda shorts? Solution 7. Bermuda shorts. The fall in orange juice futures is a sign of a good crop, which probably means speculators are expecting warm weather. 8. Take a look at Figure 7.3. If investors in the Hollywood Stock Market were too optimistic on average, would the dots tend to cluster above the red diagonal line or below it? How can you tell? Solution 8. Below it. If they are optimistic, then predicted opening revenues must be higher than the actual opening revenues, or the X-axis value has to be bigger than the Y-axis value, which means below the 45-degree line. 9. Let’s see if the forces of the market can be as efficient as a benevolent dictator. Since laptop computers are increasingly easy to build and since they allow people to use their computers wherever they like, an all-wise benevolent dictator would probably decree that most people buy laptops rather than desktop computers. This is espe¬cially true now that laptops are about as powerful as most desktops. In answering questions a–c, answer in words as well as by shifting the appropriate curves in the following figures. a. Since it’s become much easier to build better laptop computers in recent years, laptop supply has increased. What does this do to the price of laptops? b. Laptop and desktop computers are substitutes. Now that the price of laptops has changed, what does this do to the demand for desktop computers? c. And how does that affect the quantity supplied of desktop computers? d. Now let’s look at the final result: Once it became easier to build good laptops, did “invisible hand” forces push more of society’s resources into making laptops and push resources away from making desktops? (Note: Laptop sales first out¬numbered desktop sales in 2008.) Solution 9. a. The increase in supply pushes down the price of laptops. b. This reduces the demand for desktops. c. This reduces the quantity of desktops supplied. d. Yes, there are now fewer people and machines making the old, worse kind of computers. Thinking and Problem Solving 10. Andy enters into a futures contract, allowing him to sell 5,000 troy ounces of gold at $1,000 per ounce in 36 months. After that time passes, the market price of gold is $950 per troy ounce. How much does Andy make or lose? Solution 10. Andy made $250,000—he buys gold for $950 and sells it for $1,000, repeating the process 5,000 times. 11. Circa 1200 BCE, a decreasing supply of tin due to wars and the breakdown of trade led to a drastic increase in the price of bronze in the Middle East and Greece (tin being necessary for its production). It is around this time that blacksmiths developed iron- and steel-making techniques (as substitutes for bronze). a. How is the increasing price of bronze a signal? b. How is the increasing price an incentive? c. How do your answers in questions a and b help explain why iron and steel be¬came more common around the same time as the increase in price? d. After the development of iron, did the supply or demand for bronze shift? Which way did it shift? Why? Solution 11. a. It tells people that bronze is getting harder to produce, and its higher price will signal consumers to conserve it more or seek substitutes. b. It rewards people who make bronze less scarce, consumers who choose to con¬serve bronze by seeking alternatives, and entrepreneurs who seek to supply more economically efficient bronze alternatives. Thus, the price increase encourages recycling, finding new sources of tin, reducing the need for bronze (e.g., by de¬veloping technologies to make bronze products thinner or hollow), developing substitutes, and so forth. c. An increase in the price of a resource encourages innovation to produce substitutes for that resource. d. The demand for bronze shifted to the left (down) because there was now a good substitute for bronze. 12. In 1980, University of Maryland economist Julian Simon bet Stanford entomologist Paul Ehrlich that the price of any five metals of Ehrlich’s choosing would fall over 10 years. Ehrlich believed that resources would become scarcer over time as popu¬lation grew, while Simon believed that people would find good substitutes, just as earlier people developed iron as a substitute for scarce bronze. The price of all five metals that Ehrlich chose (nickel, tin, tungsten, chromium, and copper) fell over the next 10 years and Simon won the bet. Ehrlich, an honorable man, sent a check in the appropriate amount to Simon. a. What does the falling price tell us about the relative scarcity of these metals? b. What could have shifted to push these prices down: Demand or supply? And would demand have increased or decreased? And supply? Solution 12. a. The falling price indicates that the metals are relatively less scarce than what they were before. b. A falling price could have been due to a reduction in demand (caused, for example, by the development of substitutes) or supply could have increased (caused, for example, by new discoveries of these scarce resources). 13. In this chapter, we explored how prices tie all goods together. To illustrate this idea, suppose new farming techniques drastically increased the productivity of growing wheat. a. Given this change, how would the price of wheat change? b. Given your answer in question a, how would the price of cookbooks specializ¬ing in recipes using wheat flour change? c. Given your answer in question b, how would the price of paper change? d. Given your answer in question c, how would the price of pencils change? (Hint: Are paper and pencils substitutes or complements?) e. Given your answer in question d, how would the quantity of graphite (used in pencils) consumed change? Solution 13. a. Fall, because supply would shift to the right b. Increase, because demand would shift to the right c. Increase, because demand would shift to the right d. Fall, since paper and pencils are complements and so demand would shift to the left e. Fall, because demand would shift to the left 14. The law of one price states that if it’s easy to move a good from one place to an¬other, the price of identical goods will be the same because traders will buy low in one region and sell high in another. How is our story about the effect of speculators similar to the lesson about the law of one price? Solution 14. Like traders who move goods across regions, speculators buy low and sell high, except they buy and sell across time instead of national boundaries. 15. Let’s build on this chapter’s example of asphalt. Suppose a new invention comes along that makes it easier and much less expensive to recycle clothing: Perhaps a new device about the size of a washing machine can bleach, re-weave, and re-dye cotton fabric to closely imitate any cotton item you see in a fashion magazine. Head into the laundry room, drop in a batch of old clothes, scan in a couple of pages from Vogue, and come back in an hour. a. If you think of the “market for clothing” as “the market for new clothing,” does this shift the demand or the supply, and in which direction? b. If you think of the “market for clothing” as “the market for clothing, whether it’s new or used,” does this shift the demand or the supply, and in which direction? c. What will this do to the price of new, unrecycled clothing? d. After this invention, will society’s scarce productive resources (machines, workers, retail space) flow toward the “new clothing” sector or away from it? (Note: This question might sound fanciful but three-dimensional printers, which can create plastic or plaster prototypes of small items such as toys, cups, etc., have fallen dramatically in price. Every day, you’re getting just a little bit closer to hav¬ing your own personal Star Trek replicator.) Solution 15. a. This shifts the demand for clothing to the left: a fall in demand. b. This shifts the supply of clothing to the right: a rise in supply. c. Either way, this pushes down the price of new clothing. d. The scarce resources will flow away from the new clothing sector, hopefully to other, more productive uses. 16. Robin is planning to ask Peggy to the Homecoming dance. Before he asks her, he wants to know what are the chances that she’ll say yes. Robin is a scientist so he considers two paths to estimate the probability that Peggy will say yes. I. Ask 10 of his friends, “Do you think she’ll really say yes?” II. Tell another 10 of his friends, “I’m starting a betting market. I’ll pay $10 if she says yes, $0 if she says no. I’m offering this bet only once, to the highest bidder. Start bidding against each other for a chance at $10!” a. According to the evidence in this chapter, one of these methods will work better. Which one, and why? b. If the highest bid from Group II is $1 (along with a few lower bids of $0.75, $0.50, and zero), then roughly what’s the chance that Peggy will say yes to Robin? c. If the highest bid from Group II quickly shoots up to about $9, then what’s the chance that Peggy will say yes to Robin? Solution 16. a. According to the evidence, method II, the betting market, will work better. When money is on the line, people tend to be more honest and are more will¬ing to hurt their friends (or their boss’s) feelings. b. Assuming the highest bidder is the most accurate, about a 10% chance (1/10), though Robin might reduce that to take into account the knowledge of the lower (and more pessimistic) bidders. c. About a 90% chance (9/10), though, again, the true value might be lower. 17. A classic essay about how markets link each other is entitled “I, Pencil,” written by Leonard E. Read (his real name). It is available for free online at the Library of Economics and Liberty. As you might suspect, it is written from the point of view of a pencil. One line is particularly famous: “no single person on the face of this earth knows how to make me.” Based on what you’ve learned in this chapter about how markets link the world, how is this true? Solution 17. No one knows how to perform all of the steps in making a pencil: Growing the right kind of wood, making graphite, inventing safe, nontoxic paint, making the metal thing that holds the eraser onto the pencil, making the rubber eraser on the top. There are many steps, and no one person knows the ins and outs of more than a few of the steps, especially when it comes to the details. Yet the pencil is made anyway, illus¬trating how much cooperation is required and induced to produce even a simple object like a pencil. Challenges 18. In The Fatal Conceit, economist Friedrich A. Hayek, arguing against central plan¬ning, wrote: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” In other words, people generally assume that they can plan out the best procedure for producing a good (such as the Valentine’s Day rose mentioned at the beginning of the chapter) but as we learned, that’s not true. What are some of the different roles that the price system plays in creating this order? (Hint: Key words are “links,” “signals,” and “incentives.”) Solution 18. Prices link markets: A rise in price in one market encourages people to switch their demand over to other markets, reducing the pressure on the high-priced market. Markets are like a computer because they take the information from the prices and act “as if ” they know the best use of scarce goods. Prices as signals let business owners and consumers know what is plentiful and what is scarce. And prices are incentives that get people to economize on (or produce more of the) scarce goods and to switch over to using more of the inexpensive, plentiful goods. 19. One question that economics students often ask is, “In a market with a lot of buyers and sellers, who sets the price of the good?” There are two possible correct answers to this question: “Everyone” and “No one.” Choose one of the two as your answer, and explain in one or two sentences why you are correct. Solution 19. “Everyone”: In a market with many suppliers and demanders, each person’s ac¬tions push the supply or the demand just a little bit, so everyone gets a kind of vote, everyone has some small influence. “No one”: Nobody actually plans for a given price to be the equilibrium price. All of the suppliers want a higher price, and all of the demanders want a lower price. The equilibrium price was unintended by everyone, and desired by no one. 20. This chapter emphasized the ability of an orderly system to emerge without some¬one explicitly designing the entire system. How does the evolution of language illustrate a type of spontaneous order? Solution 20. Like markets, no one wrote out all the rules for any given language beforehand. They emerged over time through trial and error. The one exception to this rule is Esperanto, which no one speaks. 21. Are you in favor of “price gouging” during natural disasters? Why or why not? Solution 21. This is intentionally open-ended and intentionally inflammatory. Anti-gouging ar-guments should at least recognize the “signal flare” effect mentioned in the chapter. If anti-gougers are giving up the “signal flare” of high prices, then they’ll have to support extra government responses to make up for the absence of entrepreneurs. Pro-gougers should note that “gouging” is a subjective term, and though “goug¬ers” really are motivated by greed rather than benevolence, the net effect is getting more resources into disaster areas. It would take a very efficient government to ensure that water bottles go to the people who need it most: The gouging mecha¬nism might not be any worse than having the National Guard handing out bottles on street corners. 22. What is the opportunity cost of the economics profession? Solution 22. The opportunity cost of the field of economics is the next best thing that econo¬mists could be doing with their time. If economics didn’t exist, perhaps some potential economists would go to Wall Street to become financiers, many would go to law school, many would go to engineering or physics or biochemistry. In any of these fields, they’d probably create some value. So, to tell whether the field of economics is “worth it,” we have to compare it with the next best alternative use of all of these resources. Perhaps the world would be better off if economics disappeared, perhaps not. But by thinking in terms of opportunity cost, we sharpen our debates on the value of the field. CHAPTER 8 Modern Principles of Economics: Price Ceilings and Floors Facts and Tools 1. How does a free market eliminate a shortage? Solution 1. By letting the price rise. This encourages demanders to demand less and suppliers to supply more, ending the shortage. 2. When a price ceiling is in place, keeping the price below the market price, what’s larger: quantity demanded or quantity supplied? How does this explain the long lines and wasteful searches we see in price-controlled markets? Solution 2. A price ceiling will make quantity demanded larger than quantity supplied. Those extra demanders wait in long lines and waste effort searching for scarce goods. 3. Suppose that the quantity demanded and quantity supplied in the market for milk is as follows: a. What is the equilibrium price and quantity of milk? b. If the government places a price ceiling of $2 on milk, will there be a shortage or surplus of milk? How large will it be? How many gallons of milk will be sold? Solution 3. a. The equilibrium price is $3 and the equilibrium quantity is 3,500 gallons. b. If the government places a price ceiling of $2 on milk, there will be a shortage of 2,100 gallons. At a price of $2, suppliers will be willing to sell 2,000 gallons. 4. If a government decides to make health insurance affordable by requiring all health insurance companies to cut their prices by 30%, what will probably happen to the number of people covered by health insurance? Solution 4. This is just another price ceiling: It will create a shortage in health insurance, and not all people demanding health insurance will be covered. 5. The Canadian government has wage controls for medical doctors. To keep things simple, let’s assume that they set one wage for all doctors: $100,000 per year. It takes about 6 years to become a general practitioner or a pediatrician, but it takes about 8 or 9 years to become a specialist like a gynecologist, surgeon, or ophthalmologist. What kind of doctor would you want to become under this system? (Note: The actual Canadian system does allow specialist to earn a bit more than general practitioners, but the difference isn’t big enough to matter.) Solution 5. If both jobs pay about the same, most people would rather be a general practitioner—the job is easier, the hours are better, and you get out of school sooner. That’s actually what’s happening in Canada: They have lots of generalists and few specialists. 6. Between 2000 and 2008, the price of oil increased from $30 per barrel to $140 per barrel, and the price of gasoline in the United States rose from about $1.50 per gallon to over $4.00 per gallon. Unlike in the 1970s, when oil prices spiked, there were no long lines outside gas stations. Why? Solution 6. There were no gas lines because this time there were no price controls on oil or gasoline. 7. Price controls distribute resources in many unintended ways. In the following cases, who will probably spend more time waiting in line to get scarce, price-controlled goods? Choose one from each pair: a. Working people or retired people? b. Lawyers who charge $800 per hour or fast-food employees who earn $8 per hour? c. People with desk jobs or people who can disappear for a couple of hours during the day? Solution 7. Retired people, fast-food employees, and people who can disappear for hours are all more willing to stand in line. The opportunity cost of free time is higher for the other groups. Thus, some lawyers might pay some fast-food employees to wait in line on their behalf, as happens with ticket scalping today. 8. In the chapter, we discussed how price ceilings can put goods in the wrong place, as when too little heating oil wound up in New Jersey during a harsh winter in the 1970s. Price controls can also put goods in the wrong time as well. If there are price controls on gasoline, can you think of some periods during which the shortage will get worse? (Hint: Gas prices typically rise during the busy Memorial Day and Labor Day weekends.) Solution 8. Oil refiners and truck drivers won’t have an incentive to deliver the extra gasoline that people are demanding during holiday periods, so some people will wait in long lines for scarce gas just at the time when they most want to travel. 9. a. Consider Figure 8.8. In a price-controlled market like this one, when will consumer surplus be larger: in the short run or in the long run? b. In this market, supply is more elastic, more flexible, in the long run. In other words, in the longer term, landlords and home builders can find something else to do for a living. In light of this, and in light of the geometry of producer surplus in this figure, do rent controls hurt landlords and home builders more in the short run or in the long run? Solution 9. a. Consumer surplus will be larger in the short run, since the short-run shortage is small. Thus, in the short run, consumers get lower prices and more or less the same quantity of goods. But in the long run, the shortage increases and consumer surplus falls. In addition, in the long run, key money, long waiting times, and reductions in quality will all tend to eat up any benefit from lower prices. b. Landlords and home builders are hurt more in the short run; in the long run, they can just leave the market if things get too bad. Geometrically, we can tell this is so because less producer surplus is lost in the long run as producers exit the industry. 10. Business leaders often say that there is a “shortage” of skilled workers, and so they argue that immigrants need to be brought in to do these jobs. For example, a recent AP article was entitled “New York farmers fear a shortage of skilled workers,” and went on to point out that a special U.S. visa program, the H-2A program, “allows employers to hire foreign workers temporarily if they show that they were not able to find U.S. workers for the jobs.” (Source: Thompson, Carolyn. May 13, 2008. N.Y. farmers fear a shortage of skilled workers. Associated Press.) a. How do unregulated markets cure a “labor shortage” when there are no immigrants to boost the labor supply? b. Why are businesses reluctant to let unregulated markets cure the shortage? Solution 10. a. Unregulated markets cure a labor shortage by pushing up the wage. b. Businesses don’t like paying higher wages. They’d rather increase the supply of labor. 11. a. If the government forced all bread manufacturers to sell their products at a “fair price” that was half the current, free-market price, what would happen to the quantity supplied of bread? b. To keep it simple, assume that people must wait in line to get bread at the controlled price. Would consumer surplus rise, fall, or can’t you tell with the information given? c. With these price controls on bread, would you expect bread quality to rise or fall? Solution 11. a. The quantity supplied must fall—that’s the easy part. b. Consumer surplus must fall. The cost of waiting in line for the bread is the key: That “time-wasting” rectangle (see Figure 8.2, p. 136) eats up any extra value that might have gone to consumers. c. Bread quality is likely to fall, just as the quality of any price-controlled good is likely to fall. Think about the matzo balls! But one point to note is that if the quality of the bread falls, so will the length of the line to get it, and we do not want to double count the losses from price controls! 12. A review of the jargon: Is the minimum wage a “price ceiling” or a “price floor?” What about rent control? Solution 12. The minimum wage is a price floor, while rent control is a price ceiling. 13. How do U.S. business owners change their behavior when the minimum wage rises? How does this impact teenagers? Solution 13. When the minimum wage rises, businesses look harder for alternatives to hiring low-skilled teenagers. They might hire a smaller number of skilled older workers, they might have machines do more of the work, or they might shorten teenagers’ hours. If they can, businesses will also try to reduce other forms of on-the-job compensation such as benefits or lunch breaks. None of these are good for teenagers looking for work. 14. The basic idea of deadweight loss is that a willing buyer and a willing seller can’t find a way to make an exchange. In the case of the minimum wage law, the reason they can’t make an exchange is because it’s illegal for the buyer (the firm) to hire the seller (the worker) at any wage below the legal minimum. But how can this really be a “loss” from the worker’s point of view? It’s obvious why business owners would love to hire workers for less than the minimum wage; but if all companies obey the minimum wage law, why are some workers still willing to work for less than that? Solution 14. They’d be willing to work for less than minimum because for many workers a low-paying job is better than not working at all. The minimum wage prices some low-skilled workers out of the market. Nobel Laureate Paul Krugman wrote a famous Slate magazine essay on this topic (widely available online), “Bad jobs are better than no jobs at all.” 15. Go to the FRED economic database (https://fred.stlouisfed.org/) and search for “percent hourly paid minimum wage.” a. In 2015, what percent of hourly workers were paid the minimum wage or less? b. Hourly wage workers are about three-fifths of total workers (the remainder work on salary). Almost all salaried workers earn above the minimum wage. So what percent of all workers earn the minimum wage or less? Solution 15. a. 3.3% b. Since 3/5 × 3.3% = 1.98%, less than 2% of all workers earn the minimum wage or less. Thinking and Problem Solving 16. In rich countries, governments almost always set the fares for taxi rides. The prices for taxi rides are the same in safe neighborhoods and in dangerous neighborhoods. Where is it easier to find a cab? Why? If these taxi price controls were ended, what would probably happen to the price and quantity of cab rides in dangerous neighborhoods? (Aside: How do you think ride-sharing apps like Uber and Lyft have affected this problem?) Solution 16. Driving a taxi in a major city is a relatively dangerous job. Since taxi drivers prefer to drive in safe neighborhoods it is probably easier to find a cab in a safe neighborhood. If price controls were ended, taxis could charge more in dangerous neighborhoods, and they would probably drive there more often. Ride-sharing apps like Uber and Lyft are safer for drivers since there is a record of whom they are picking up, and unlike taxi drivers, Uber and Lyft drivers don't carry cash. Drivers are thus more willing to pick up in any neighborhood, and they are less likely to discriminate (in fact, Uber drivers are required to accept most of their ride requests). 17. When the United States had price controls on oil and gasoline, some parts of the United States had a lot of heating oil while other states had long lines. As in the chapter, let’s assume that winter oil demand is higher in New Jersey than in California. If there had been no price controls, what would have happened to the prices of heating oil in New Jersey and in California and how would “greedy businesspeople” have responded to these price differences? Solution 17. If the demand for heating oil rose in New Jersey, then the price in New Jersey would rise relative to that in California. This would encourage greedy businesspeople to ship the gasoline on trucks or in pipelines from California to New Jersey until prices equalized. This would reduce the shortage in New Jersey. 18. On January 31, 1990, the first McDonald’s opened in Moscow, capital of the then Soviet Union. Economists often described the Soviet Union as a “permanent short¬age economy,” where the government kept prices permanently low in order to appear “fair.” “An American journalist on the scene reported the customers seemed most amazed at the ‘simple sight of polite shop workers . . . in this nation of commercial boorishness.’ ” a. Why were most Soviet shop workers “boorish” while the McDonald’s workers in Moscow were “polite”? b. What does your answer to the previous question tell you about the power of economic incentives to change human behavior? In other words, how entrenched is “culture”? Solution 18. a. The Soviet shop workers were mean because they worked in a world of short-ages: No matter how badly they behaved, all the goods would end up sold. The McDonald’s workers were trained to be polite because McDonald’s always faces competition from other restaurants. If their workers are boorish, customers will go somewhere else. b. This is an example of how market incentives can change human behavior. Human “nature” looks pretty flexible when money is on the line. 19. Let’s count the value of lost gains from trade in a regulated market. The government decides it wants to make basic bicycles more affordable, so it passes a law requiring that all one-speed bicycles sell for $30, well below the market price. Use the following data to calculate the lost gains from trade, just as in Figure 8.3. Supply and demand are straight lines. a. What is the total value of wasted time in the price-controlled market? b. What is the value of the sum of lost consumer surplus and lost producer surplus? c. Note that we haven’t given you the original market price of simple bicycles—why don’t you need to know it? (Hint: The answer is a mix of geometry and economics.) Solution 19. a. $50 × 100 = $5,000 b. $50 × 100 × 0.5 = $2,500. This is the triangle formula again. c. You don’t need to know the market price because we don’t need to know all the dimensions of a triangle to measure its area, and because “willingness to pay,” “willingness to supply,” and the equilibrium quantity and the price-controlled quantity tell us all we need to know. 20. During a crisis such as Hurricane Sandy, governments often make it illegal to raise the price of emergency items like flashlights and bottled water. In practice, this means that these items get sold on a first-come, first-served basis. a. If a person has a flashlight that she values at $5, but its price on the black market is $40, what gains from trade are lost if the government shuts down the black market? b. Why might a person want to sell a flashlight for $40 during an emergency? c. Why might a person be willing to pay $40 for a flashlight during an emergency? d. When will entrepreneurs be more likely to fill up their pickup trucks with flashlights and drive into a disaster area: when they can sell their flashlights for $5 each or when they can sell them for $40 each? Solution 20. a. The total gains from trade if trade is allowed are $35; these gains from trade would be split between the buyer and the seller, depending on the exact price they agreed upon. b. Many reasons are possible. The person might have another flashlight, or might have candles, or might need money to buy water or medicine or food more than he needs a flashlight. c. A person might really need a flashlight because she has no candles or other lights, or she might need to visit a sick relative late at night. There are many reasons why she might need it. d. When the price is $40, entrepreneurs are more likely to drive in with pickup trucks full of flashlights. 21. A “black market” is a place where people make illegal trades in goods and services. For instance, during the Soviet era, it was common for American tourists to take a few extra pairs of Levi’s jeans when visiting the Soviet Union: They would sell the extra pairs at high prices on the illegal black market. Consider the following claim: “Price-controlled markets tend to create black markets.” Let’s illustrate with the following figure. If there is a price ceiling in the market for cancer medication of $50 per pill, what is the widest price range within which you can definitely find both a buyer and a seller who would be willing to il-legally exchange a pill for money? (There is only one correct answer.) Solution 21. Between $50 and $160, you can find both a buyer and a seller who are definitely willing to trade money for a pill. That creates a big incentive for a black market. The price can’t be higher than $160 because those demanders might be getting their pills in the price-controlled market. And it can’t be below $50 because those suppliers might already be supplying the price-controlled market. 22. So, knowing what you know now about price controls, are you in favor of setting a $2 per gallon price ceiling on gasoline? Create a pro–price control and an anti–price control answer. Solution 22. A plausible pro-price control answer: The people we worry about the most are the poor, and the poor place a low value on their time, so it’s less of a waste if they spend hours waiting in gas lines. Thus, while there will be long lines, this might be a reasonable way to redistribute wealth from the rich to the poor. A plausible anti-price control answer: Price controls on gasoline create many kinds of waste: waste from gasoline that doesn’t get supplied, waste from people waiting in line, and the waste from the black markets that are likely to arise. Taken together, it’s hard to argue that anyone would benefit much from price controls on gasoline and many people will be harmed. It might feel good, but it will probably create bad outcomes that we’ll regret. 23. a. As we noted, Assar Lindbeck once said that short of aerial bombardment, rent control is the best way to destroy a city. What do you think Lindbeck might mean by this? b. How does paying “key money” to a landlord reduce the severity of Lindbeck’s “bombardment”? Solution 23. a. Lindbeck probably means that in a rent-controlled city, landlords will let the quality of their housing stock decline. In many price-controlled markets, product quality does fall, and in housing markets, it’s easy for a landlord to just let the apartment slowly fall apart. After all, with a government-created housing shortage, it should be easy to rent out the room even if the electrical wiring is bad. b. If people can pay “key money,” then it is as if they are making a higher rent payment. It is a way around the rent control. In places where it’s possible (though illegal) to pay key money, we would expect more apartments to remain in good condition. 24. In the town of Freedonia, the government declares that all street parking must be free: There can be no parking meters. In the almost identical town of Meterville, parking costs $5 per hour (or $1.25 per 15 minutes). a. Where will it be easier to find parking: in Freedonia or Meterville? b. One town will tend to attract shoppers who hate driving around looking for parking. Which one? c. Why will the town from part b also attract shoppers with higher incomes? Solution 24. a. Meterville. In Freedonia, there will be a shortage of parking spots. In Meterville, there will be parking for those willing to pay the price. b. Meterville, again. Their stronger preference for easy-to-find parking suggests a higher willingness to pay for it. Thus, the meters are a worthwhile price to pay to ensure a parking space. c. People who have money to spend on meters typically have a higher opportunity cost for their free time. That typically means they earn higher wages. 25. In the late 1990s, the city of Santa Monica, California, made it illegal for banks to charge people ATM fees. As you probably know, it’s almost always free to use your own bank’s ATMs, but there’s usually a fee charged when you use another bank’s ATM. (Source: The War on ATM Fees, Time, November 29, 1999). As soon as Santa Monica passed this law, Bank of America stopped allowing customers from other banks to use their ATMs: In bank jargon, B of A banned “out-of-network” ATM usage. In fact, this ban lasted for only a few days, after which a judge allowed banks to continue to charge fees while awaiting a full court hearing on the issue. Eventually, the court declared the fee ban illegal under federal law. But let’s imagine the effect of a full ban on out-of-network fees. a. In the figure, indicate the new price per out-of-network ATM transaction after the fee ban. Also clearly label the shortage. b. Calculate the exact amount of producer and consumer surplus in the out-of-network ATM market in Santa Monica after the ban. How large is producer surplus? How large is consumer surplus? Solution 25. a. b. When a market is shut down completely, as occurs here, there is no producer surplus and no consumer surplus. Surplus only comes from exchange, so when there’s no exchange, there’s just no surplus! Both are zero. 26. Consider Figure 8.9. Your classmate looks at that chart and says, “Apartment con¬struction slowed down years before rent control was passed, and after rent control was passed, more apartments were built. Rent control didn’t cut the number of new apartments, it raised it. This proves that rent control works.” What is wrong with this argument? Solution 26. The problem is that builders changed their behavior before the bill became law: As soon as politicians started debating the bill, new apartment starts dropped. They only recovered a tiny amount after the bill was passed. To measure the effect of legislation on economic decisions, we need to know when people learned about the possibility of legislation. People are forward looking, reacting today to likely future policy changes. This was one big insight from the rational expectations revolution of 1970s macroeconomics. 27. Rent control creates a shortage of housing, which makes it hard to find a place to live. In a price-controlled market, people have to waste a lot of time trying to find these scarce, artificially cheap products. Yet Congressman Charles B. Rangel, the chairman of the powerful House Ways and Means Committee, lived in four rent-stabilized apartments in Harlem. Why are powerful individuals often able to “find” price-controlled goods much more often than the non-powerful? What does this tell us about the political side effects of price controls? (Source: Republicans question Rangel’s tax break support, The New York Times, November 25, 2008.) Solution 27. If a scarce good can’t be rationed through prices, it will be rationed in some other way. Landlords who must rent at below-market prices will attempt to ration out their scarce goods so that they can get the most value possible. Landlords under rent control will tend to favor powerful politicians, celebrities, or family members. “Who you know” will matter quite a lot—this is just the U.S. equivalent of what the Russians call blat. 28. In the 1970s, AirCal and Pacific Southwest Airlines flew only within California. As we mentioned, the federal price floors didn’t apply to flights within just one state. A major route for these airlines was flying from San Francisco to Los Angeles, a distance of 350 miles. This is about the same distance as from Chicago, Illinois, to Cleveland, Ohio. Do you think AirCal flights had nicer meals than flights from Chicago to Cleveland? Why or why not? Solution 28. AirCal flights were cheaper but had worse meals than flights from Chicago to Cleveland. This is because in the unregulated California market, businesses didn’t have to provide inefficiently high quality to make up for the extra-high price. Instead, Californians could get lots of cheap flights with peanuts and soda. 29. President Jimmy Carter didn’t just deregulate airline prices. He also deregulated much of the trucking industry as well. Trucks carry almost all of the consumer goods that you purchase, so almost every time you purchase something, you’re paying money to a trucking company. a. Based on what happened in the airline industry after prices were deregulated, what do you think happened in the trucking industry after deregulation? You can find some answers here: http://www.econlib.org/Library/Enc/Trucking¬Deregulation.html. For another look that is critical of trucking deregulation but comes to basically the same answers, see Michael Belzer, 2000. Sweatshops on Wheels: Winners and Losers in Trucking Deregulation, Thousand Oaks, CA: SAGE. b. Who do you think asked Congress and the president to keep price floors for trucking: consumer groups, retail shops like Walmart, or the trucking companies? Solution 29. a. After trucking was deregulated, the price of trucking services fell. Truckers earned less money and it became cheaper to ship goods across country. This saved consumers a lot of money. b. The trucking companies probably wanted the price floors: They liked getting high prices for their trucking services. 30. Suppose you’re doing some history research on shoe production in ancient Rome, during the reign of the famous Emperor Diocletian. Your documents tell you how many shoes were produced each year in the Roman Empire, but they don’t tell you the price of shoes. You find a document stating that in the year 301, Emperor Diocletian issued an “edict on prices,” but you don’t know whether he imposed price ceilings or price floors—your Latin is a little rusty. However, you can clearly tell from the documents that the number of shoes actually sold in markets fell dramatically, and that both potential shoe sellers and potential shoe buyers were un¬happy with the edict. With the information given, can you tell whether Diocletian imposed a ceiling or a floor? If so, which is it? (Yes, there really was an edict of Diocletian, and Wikipedia has excellent coverage of ancient Roman history.) Solution 30. You can’t tell with the information given. Both price ceilings and price floors reduce the quantity of goods traded in markets. (Yes, a price floor creates a surplus but in real life those goods don’t really get made after businesses realize they can’t sell all the extra shoes.) But, in fact, Diocletian’s edict was a price ceiling: He made it illegal to charge more than a certain price for various goods, specifically including shoes. It really did hurt the quantity of trade in the Roman Empire, at a time when the empire was already facing major political troubles. 31. In the market depicted in the figure, there is either a price ceiling or a price floor—surprisingly, it doesn’t matter which one it is: Whether it’s an $80 price floor or a $30 price ceiling, the chart looks the same. In the chart, there’s a rectangle and a triangle. One represents the value lost from the “deals that don’t get made” and one represents the value lost from “the deals that do get made.” Which is which? Solution 31. Triangle B represents value lost from the “deals that don’t get made.” Rectangle A represents the value lost in the “deals that do get made”: the waiting in line by con¬sumers if it’s a price ceiling, or the wasteful searching (e.g., advertising, marketing) by suppliers if it’s a price floor. 32. We noted that in the 1970s price floors on airline tickets caused wasteful increases in the quality of airline trips. Does the minimum wage cause wasteful increases in the quality of workers? If so, how? In other words, how are minimum-wage workers like airplane trips? Solution 32. When workers cannot compete to obtain a job by offering to work at a lower wage, they will compete in other ways, such as by searching longer or by investing more in skills. Similarly, firms who must pay a minimum wage will try harder to sort workers so they can hire only the most skilled. Although it is good to have skills, it is possible to invest too much in them (just as it is possible to have a wastefully high quality of airline meal). If a minimum-wage job at McDonald’s paid $25 an hour, for example, McDonald’s might hire only workers who spoke two or more languages. That’s nice, but it’s not the most productive use of a talented workforce. 33. The city of Mumbai in India imposed rent controls on apartments in 1947. Despite inflation and changes in land value, allowable rents have hardly increased since that time! Use what you know about rent controls to speculate about the quality of rent-controlled buildings in Mumbai. Solution 33. Rents in Mumbai are far below market levels. Millions of people pay just a few dollars a month but at those prices landlords have few incentives or funds to maintain their buildings. As a result, many rent-control buildings are in such a state of disrepair that collapse is not uncommon. See the following two articles: Bellman, Eric. 2006. “Tenants in Mumbai Will Endure a Lot For an $8.50 Flat.” Wall Street Journal, June 5, sec. News. http://www.wsj.com/articles/SB114947402053671201 Thakur, Pooja. 2012. “Tossed-Out $20 Tenants Turn Millionaires in Mumbai.” Bloomberg.com, June 26. http://www.bloomberg.com/news/articles/2012-06-26/tossed-out-20-tenants-turn-millionaires-in-mumbai. Challenges 34. If a government decided to impose price controls on gasoline, what could it do to avoid the time wasted waiting in lines? There is surely more than one solution to this problem. Solution 34. One method is to make it pointless to wait in line by restricting the quantity of gasoline that any individual can consume. During World War II, for example, the United States Office of Price Administration (OPA) limited every person in the United States to a certain amount of coffee, sugar, shoes, and gasoline (as well as many other goods). To purchase gasoline a driver had to certify that they needed gasoline and that they owned no more than five tires. (The government confiscated all tires in excess of five per driver because of rubber shortages.) Most cars were limited to 3–4 gallons of gasoline a week. To buy gasoline drivers had to present their ration books and a stamp for every gallon of gasoline that they wanted to purchase. The ration books limited time wasted in lines, but the rationing system had greater administrative costs. 35. In New York City, some apartments are under strict rent control, while others are not. This is a theme in many novels and movies about New York, including Bonfire of the Vanities and When Harry Met Sally. One predictable side effect of rent control is the creation of a black market. Let’s think about whether it’s a good idea to allow this black market to exist. a. Harry is lucky enough to get a rent-controlled apartment for $300 per month. The market rent on such an apartment is $3,000 per month. Harry himself values the apartment at $2,000 per month, and he’d be quite happy with a regular, $2,000 per month New York apartment. If he stays in the apartment, how much consumer surplus does he enjoy? b. If he illegally subleases his apartment to Sally on the black market for $2,500 per month and instead rents a $2,000 apartment, is he better off or worse off than if he obeyed the law? Solution 35. a. $1,700 per month b. He is better off if he subleases the apartment—he can move into a regular $2,000 per month apartment plus have $500 in spending money left over. This kind of resale is very common in rent-controlled markets. It was made famous in the Tom Wolfe novel Bonfire of the Vanities. 36. Let’s measure consumer surplus if the government imposes price controls and goods end up being randomly allocated among those consumers willing to pay the controlled price. If the demand and supply curves are as in the figure, then: a. What is consumer surplus under the price control? b. What would consumer surplus be if the quantity supplied were 1,000 but the goods were allocated to the highest-value users? Solution 36. a. If each consumer with value between $110 and $10 stands an equal chance of getting the good, then on average each of the 1,000 units sold will be valued at $60. Thus, consumer surplus under random allocation will be ($60 − $10) × 1,000 = $50,000. b. If there were no price controls (but the quantity supplied was still 1,000), the buyers with the highest valued uses would outbid the other buyers and total consumer surplus would be the area under the demand curve and above the price up to the quantity supplied—this has an area of 1/2 × ($110 − $100) × 1,000 + ($100 − $10) × 1,000 = $95,000. 37. Antibiotics are often given to people with colds (even though they are not useful for that purpose), but they are also used to treat life-threatening infections. If there was a price control on antibiotics, what do you think would happen to the alloca¬tion of antibiotics across these two uses? Solution 37. Although antibiotics are often overused (for more on this see Chapter 10), if some¬one does have a life-threatening infection, they can usually get all the antibiotics they need by outbidding other potential users of antibiotics who have less-valued uses. A price control on antibiotics would create a shortage. If antibiotics were allocated efficiently, the quantity supplied would go only to those with life-threat¬ening infections, the highest-valued users. But it is also possible, and perhaps likely, that under price controls the antibiotics would not be allocated efficiently. Without prices, there would no longer be a signal nor an incentive to deliver antibiotics to the users with the highest demands. Just as oil can be misallocated between warm California and cold New Jersey, a price control on antibiotics would probably lead to a tragic misallocation of antibiotics between high- and low-valued users. 38. In a command economy, such as the old Soviet Union, there were no prices for almost all goods. Instead, goods were allocated by a “central planner.” Suppose that a good like oil becomes more scarce. What problems would a central planner face in reallocating oil to maximize consumer plus producer surplus? Solution 38. This is a big question that goes to the heart of why a market economy is more efficient than a centrally planned economy. All of the price features that we have discussed are important, particularly the fact that a price signals information and provides an incentive to use that information in a socially beneficial way. If oil becomes scarce, the central planner would like (this is a big assumption!) to allocate the remaining oil to the most highly valued uses—but how are those uses to be discovered without prices? To allocate oil correctly, the central planner would need to know every use of oil, the substitutes for oil in every use, the substitutes for the substitutes, and so forth. Even collecting all the relevant information would be impossible, and by the time the information was collected, it would be irrelevant! Remember that when the Department of Energy tried to allocate just one good, oil, to its most highly valued uses, it did not allocate enough to oil rigs! What would happen if a central planner had to allocate every good? Hayek’s “The Use of Knowledge in Society” and Ludwig von Mises’s “Economic Calculation in the Socialist Commonwealth,” both easily available on the web, are relevant. Of course, this chapter and Chapter 7 are highly relevant, as well! 39. Labor unions are some of the strongest proponents of the minimum wage. Yet in 2008, the median full-time union member earned $886 per week, an average of over $22 per hour (http://www.bls.gov/news.release/union2.nr0.htm). Therefore, a rise in the minimum wage doesn’t directly raise the wage of many union workers. So why do unions support minimum wage laws? Surely, there’s more than one reason why this is so, but let’s see if economic theory can shed some light on the subject. a. Skilled and unskilled labor are substitutes: For example, imagine that you can hire four low-skilled workers to move dirt with shovels at $5 an hour, or you can hire one skilled worker at $24 an hour to move the same amount of dirt with a skid loader. Using the tools developed in Chapter 4, what will happen to the demand for skilled labor if the price of unskilled labor increases to $6.50 per hour? b. If the minimum wage rises, will that increase or decrease the demand for the average union worker’s labor? Why? c. Now, let’s put the pieces together: Why might high-wage labor unions support an increase in the minimum wage? Solution 39. a. At a wage of $5, it is cheaper to hire 4 low-skilled workers than to hire one skilled worker. However, if the wage is $6.50, then 4 low-skilled workers would cost $26, making the skilled worker cheaper. This increase in the wage of low-skilled workers will reduce the demand for this type of work. b. If the minimum wage rises, that will increase the demand for the average union worker’s labor, because the competition (unskilled labor) is getting priced out of the market. c. Unions might support a rise in the minimum wage because it makes high-wage union labor more attractive than lower-wage labor. 40. In our Uber example, we said that after a spike in demand around Madison Square Garden, the number of Uber rides increased by more than 75% in the surrounding area, but when it starts to rain, Uber rides increase by the still substantial but lesser amount of 25%. Can you suggest one reason why the supply response is different in the two situations? (Hint: Think about elasticities of supply.) Solution 40. The elasticity of supply is probably larger for a surge in a local area than it is for the larger New York City area. Why? The Madison Square Garden example is a local increase and can be met by more Uber drivers coming from other parts of NYC to the area around Madison Square Garden. In contrast, when it’s raining, it’s probably raining in most of NYC, so the supply response must come from Uber drivers who work longer hours when it’s raining or from “opportunistic” Uber drivers who turn on Uber and start to drive when the surge price is high. Sometimes economists refer to the intensive margin (Uber drivers working more) and the extensive margin (more Uber drivers). Thus, we are suggesting that the supply response is larger on the intensive margin than on the extensive margin, at least in the short run. Solution Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766
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