CH-7-9 Taxes – Microeconomics : Book Guide

This Document Contains Chapters 7 to 9 Taxes Chapter 7. The United States imposes an excise tax on the sale of domestic airline tickets. Let’s assume that in 2015 the total excise tax was $6.10 per airline ticket (consisting of the $3.60 flight segment tax plus the $2.50 September 11 fee). According to data from the Bureau of Transportation Statistics, in 2015, 643 million passengers traveled on domestic airline trips at an average price of $380 per trip. The accompanying table shows the supply and demand schedules for airline trips. The quantity demanded at the average price of $380 is actual data; the rest is hypothetical. Price of trip Quantity of trips demanded (millions) Quantity of trips supplied (millions) $380.02 642 699 380.00 643 698 378.00 693 693 373.90 793 643 373.82 913 642 a. What is the government tax revenue in 2015 from the excise tax? b. On January 1, 2016, the total excise tax increased to $6.20 per ticket. What is the equilibrium quantity of tickets transacted now? What is the average ticket price now? What is the 2016 government tax revenue? c. Does this increase in the excise tax increase or decrease government tax revenue? 1. a. Tax revenue is $6.10 per trip × 643 million trips = $3,922.3 million. b. The equilibrium quantity now falls to 642 million, with the price rising to $380.02. Tax revenue rises to $6.20 per trip × 642 million trips = $3,980.40 million. c. The increase in the excise tax increases government tax revenue. 2. In 1990, the United States began to levy a tax on sales of luxury cars. For simplicity, assume that the tax was an excise tax of $6,000 per car. The accompanying figure shows hypothetical demand and supply curves for luxury cars. Price of car (thousands of dollars) $56 55 54 53 52 51 50 49 48 47 0 E S D 20 40 60 80 100 120 140 Quantity of cars (thousands) 7 a. Under the tax, what is the price paid by consumers? What is the price received by producers? What is the government tax revenue from the excise tax? Over time, the tax on luxury automobiles was slowly phased out (and completely eliminated in 2002). Suppose that the excise tax falls from $6,000 per car to $4,500 per car. b. After the reduction in the excise tax from $6,000 to $4,500 per car, what is the price paid by consumers? What is the price received by producers? What is tax revenue now? c. Compare the tax revenue created by the taxes in parts a and b. What accounts for the change in tax revenue from the reduction in the excise tax? 2. a. The price paid by consumers is $54,000. The price received by producers is $48,000. The government’s tax revenue is $6,000 per car × 40,000 cars = $240 million. b. The price paid by consumers is now $53,000. The price received by producers is $48,500. The government’s tax revenue is $4,500 per car × 60,000 cars = $270 million. c. The government tax revenue rose as a result of the reduction in the excise tax. This occurs because the supply of and the demand for luxury automobiles are both highly elastic: a fall in the price paid by consumers leads to a large increase in the quantity demanded, and a rise in the price received by producers leads to a large increase in the quantity supplied. As a result, reducing the tax leads to a large increase in the quantity of luxury automobiles bought and sold—so large, in fact, that the increase in the quantity bought and sold more than makes up for the decrease in the tax per car. 3. All states impose excise taxes on gasoline. According to data from the Federal Highway Administration, the state of California imposes an excise tax of $0.40 per gallon of gasoline. In 2015, gasoline sales in California totaled 14.6 billion gallons. What was California’s tax revenue from the gasoline excise tax? If California doubled the excise tax, would tax revenue double? Why or why not? 3. Tax revenue is $0.40 per gallon × 14.6 billion gallons = $5.84 billion. Doubling the excise tax would reduce the amount of gasoline bought and sold, and tax revenue would less than double. The exception would be a case in which either demand or supply is perfectly inelastic; only in that special case would the quantity transacted not change as a result of the imposition of the excise tax, and tax revenue would—in this special case only—double as a result of a doubling in the excise tax rate. 4. In the United States, each state government can impose its own excise tax on the sale of cigarettes. Suppose that in the state of North Texarkana, the state government imposes a tax of $2.00 per pack sold within the state. In contrast, the neighboring state of South Texarkana imposes no excise tax on cigarettes. Assume that in both states the pre-tax price of a pack of cigarettes is $1.00. Assume that the total cost to a resident of North Texarkana to smuggle a pack of cigarettes from South Texarkana is $1.85 per pack. (This includes the cost of time, gasoline, and so on.) Assume that the supply curve for cigarettes is neither perfectly elastic nor perfectly inelastic. a. Draw a diagram of the supply and demand curves for cigarettes in North Texarkana showing a situation in which it makes economic sense for a North Texarkanan to smuggle a pack of cigarettes from South Texarkana to North Texarkana. Explain your diagram. b. Draw a corresponding diagram showing a situation in which it does not make economic sense for a North Texarkanan to smuggle a pack of cigarettes from South Texarkana to North Texarkana. Explain your diagram. c. Suppose the demand for cigarettes in North Texarkana is perfectly inelastic. Draw a corresponding diagram to illustrate how high the cost of smuggling a pack of cigarettes could go until a North Texarkanan no longer found it profitable to smuggle. Explain your diagram. d. Still assume that demand for cigarettes in North Texarkana is perfectly inelastic and that all smokers in North Texarkana are smuggling their cigarettes at a cost of $1.85 per pack, so no tax is paid. Is there any inefficiency in this situation? If so, how much per pack? Suppose chip-embedded cigarette packaging makes it impossible to smuggle cigarettes across the state border. Is there any inefficiency in this situation? If so, how much per pack? 4. a. In the accompanying figure, the demand for cigarettes in North Texarkana is relatively inelastic. So most of the $2.00 tax is borne by consumers, who pay an after-tax price of $2.95. Since it would cost $2.85 to purchase and smuggle a pack from South Texarkana ($1.00 price per pack + $1.85 smuggling cost per pack), this diagram illustrates a situation in which a North Texarkanan would be better off smuggling rather than purchasing cigarettes in North Texarkana. Price of cigarettes (per pack) S A $2.95 Excise tax = $2.00 per pack 1.00 0.95 E B D Quantity of cigarettes (packs) 0 b. In the accompanying diagram, the demand in North Texarkana is less inelastic. As a result, consumers pay an after-tax price of $2.50. In this case, it does not make economic sense to smuggle. Price of cigarettes (per pack) S A $2.50 Excise tax = $2.00 per pack 1.00 0.50 0 E B D Quantity of cigarettes (packs) c. As shown in the accompanying diagram, if the demand for cigarettes in North Texarkana is perfectly inelastic, the demand curve is a vertical line and all of the tax is borne by consumers. In that case, the after-tax price paid by North Texarkanans is $3.00. So the cost of smuggling could go as high as $1.99, and North Texarkanans would still be better off smuggling; at a cost of $2.00 to smuggle, they would be indifferent between smuggling and purchasing their cigarettes in their home state. Price of cigarettes (per pack) $3.00 A S Excise tax = $2.00 per pack 1.00 E D 0 Quantity of cigarettes (packs) d. Since demand is perfectly inelastic, the same number of cigarettes are transacted after the tax is imposed compared to before the tax is imposed. But there is still an inefficiency incurred in this situation despite the fact that no tax is paid and no transactions are discouraged: it is the $1.85 that is spent to smuggle a pack of cigarettes. This is the value of resources spent to evade the tax that consumers would have preferred to spend on other goods and activities. If technology eliminates smuggling altogether, there is no inefficiency. Because demand is perfectly inelastic, no transactions are discouraged by the tax, and all of the surplus lost by consumers is captured by the government as tax revenue. 5. In each of the following cases involving taxes, explain: (i) whether the incidence of the tax falls more heavily on consumers or producers, (ii) why government revenue raised from the tax is not a good indicator of the true cost of the tax, and (iii) how deadweight loss arises as a result of the tax. a. The government imposes an excise tax on the sale of all college textbooks. Before the tax was imposed, 1 million textbooks were sold every year at a price of $50. After the tax is imposed, 600,000 books are sold yearly; students pay $55 per book, $30 of which publishers receive. b. The government imposes an excise tax on the sale of all airline tickets. Before the tax was imposed, 3 million airline tickets were sold every year at a price of $500. After the tax is imposed, 1.5 million tickets are sold yearly; travelers pay $550 per ticket, $450 of which the airlines receive. c. The government imposes an excise tax on the sale of all toothbrushes. Before the tax, 2 million toothbrushes were sold every year at a price of $1.50. After the tax is imposed, 800,000 toothbrushes are sold every year; consumers pay $2 per toothbrush, $1.25 of which producers receive. 5. a. After the imposition of the tax, consumers pay $5 more per book than before; publishers receive $20 less per book than before. Producers (publishers) bear more of the tax. The tax is $55 − $30 = $25 per book, and 600,000 books are bought and sold. So government revenue is $15 million. This, however, is a poor estimate of the cost of the tax, since it does not take into account the fact that, in addition to the higher price, there are now 400,000 potential consumers who would have bought the books without the tax but no longer will buy them. Deadweight loss arises because consumers and producers lose surplus that is not captured as government revenue. That loss in surplus is accounted for by the 400,000 potential consumers and publishers who would have made transactions without the tax but do not once the tax is levied. b. After the imposition of the tax, travelers pay $50 more per ticket than before; airlines receive $50 less than before. The tax is split evenly between consumers and producers. The tax is $550 − $450 = $100 per ticket, and 1.5 million tickets are bought and sold. So government revenue is $150 million. This, however, is a poor estimate of the cost of the tax, since it does not take into account the fact that, in addition to 1.5 million travelers paying higher prices, there are now 1.5 million potential consumers who would have bought tickets without the tax but no longer buy tickets. Deadweight loss arises because consumers and producers lose surplus that is not captured as government revenue. That loss in surplus is represented by the 1.5 million tickets that would have been transacted at the pre-tax price but are not transacted once the tax is levied. c. After the imposition of the tax, consumers pay $0.50 more per toothbrush than before; producers receive $0.25 less than before. The incidence of the tax falls mainly on consumers. The tax is $2.00 − $1.25 = $0.75 per toothbrush, and 800,000 toothbrushes are bought and sold. So government revenue is $600,000. This, however, is a poor estimate of the cost of the tax, since it does not take into account the fact that, in addition to 800,000 toothbrushes now being more expensive, there are 1.2 million toothbrushes that would have been transacted without the tax but are no longer transacted. Inefficiency arises because consumers and producers lose surplus that is not captured as government revenue. That loss in surplus is represented by the 1.2 million toothbrushes that would have been transacted at the pre-tax price but are not transacted once the tax is levied. 6. The accompanying diagram shows the market for cigarettes. The current equilibrium price per pack is $4, and every day 40 million packs of cigarettes are sold. In order to recover some of the health care costs associated with smoking, the government imposes a tax of $2 per pack. This will raise the equilibrium price to $5 per pack and reduce the equilibrium quantity to 30 million packs. Price of cigarettes (per pack) $8 S Excise tax = $2 5 4 3 E D 0 30 40 Quantity of cigarettes (millions of packs per day) The economist working for the tobacco lobby claims that this tax will reduce consumer surplus for smokers by $40 million per day, since 40 million packs now cost $1 more per pack. The economist working for the lobby for sufferers of second-hand smoke argues that this is an enormous overestimate and that the reduction in consumer surplus will be only $30 million per day, since after the imposition of the tax only 30 million packs of cigarettes will be bought and each of these packs will now cost $1 more. They are both wrong. Why? Include a ­calculation of consumer surplus before and after the tax in your answer. 6. The economist working for the tobacco lobby is overestimating the change in consumer surplus. She is assuming that there will be no change in the quantity demanded and that consumers will continue to smoke 40 million packs of cigarettes per day even when the price has risen by $1 per pack. The economist working for the second-hand smoke lobby is underestimating the loss of consumer surplus. He calculates the loss of consumer surplus to be $30 million: $1 per pack times the number of packs per day that are still sold, 30 million. He fails to count the loss of consumer surplus to those who smoke less or none at all after the tax, accounted for by the fall in consumption from 40 million to 30 million packs per day. We can calculate the loss in consumer surplus from the tax by comparing the total consumer surplus before the tax is levied to the total consumer surplus after. Recall that the area of a triangle is 1⁄2 × the base of the triangle × the height of the triangle. Before the tax the consumer surplus was 1⁄2 × ($8 − $4) × 40 million = $80 million. After the tax, the consumer surplus is 1⁄2 × ($8 − $5) × 30 million = $45 million. The reduction in consumer surplus is $80 million − $45 million = $35 million. 7. Consider the original market for pizza in Collegetown, illustrated in the accompanying table. Collegetown officials decide to impose an excise tax on pizza of $4 per pizza. Price of pizza Quantity of pizza demanded Quantity of pizza supplied $10 0 6 9 1 5 8 2 4 7 3 3 6 4 2 5 5 1 4 6 0 3 7 0 2 8 0 1 9 0 a. What is the quantity of pizza bought and sold after the imposition of the tax? What is the price paid by consumers? What is the price received by producers? b. Calculate the consumer surplus and the producer surplus after the imposition of the tax. By how much has the imposition of the tax reduced consumer surplus? By how much has it reduced producer surplus? c. How much tax revenue does Collegetown earn from this tax? d. Calculate the deadweight loss from this tax. 7. a. The tax drives a wedge between the price paid by consumers and the price received by producers. Consumers now pay $9, and producers receive $5. So after the imposition of the tax, the quantity bought and sold will be one pizza. b. Consumer surplus is now zero (the one consumer who still buys a pizza at $9 has a willingness to pay of just $9, so that the consumer surplus is $9 − $9 = $0). Compared to the situation before the imposition of the tax, where the equilibrium price was $7, consumer surplus has fallen by $3. (At a price of $7, the person willing to pay $9 receives surplus of $2, the person willing to pay $8 receives surplus of $1, and the person willing to pay $7 receives surplus of $0.) Similarly, the producer of the one pizza has a cost of $5, and this is the price he receives, so producer surplus is also zero. Compared to pre-tax producer surplus, it has fallen by $3. (At a price of $7, the producer willing to accept $5 receives surplus of $2, the producer willing to accept $6 receives surplus of $1, and the producer willing to accept $7 receives surplus of $0.) c. Collegetown earns a tax of $4 per pizza sold, which is a total tax revenue of $4. d. Total surplus has been decreased by $6. Of that $6, the town earns $4 in ­revenue, but $2 of surplus is lost. The deadweight loss from this tax is $2. 8. The state needs to raise money, and the governor has a choice of imposing an excise tax of the same amount on one of two previously untaxed goods: restaurant meals or gasoline. Both the demand for and the supply of restaurant meals are more elastic than the demand for and the supply of gasoline. If the governor wants to minimize the deadweight loss caused by the tax, which good should be taxed? For each good, draw a diagram that illustrates the deadweight loss from taxation. 8. The tax should be imposed on sales of gasoline. Since both demand for and supply of gasoline are less elastic, changes in the price of gasoline will result in smaller reductions in the quantity demanded and quantity supplied. As a result, fewer transactions are discouraged by the tax—in other words, less total surplus (consumer and producer surplus) is lost. Panel (a) of the accompanying diagram illustrates a tax imposed on sales of gasoline, for which both demand and supply are less elastic; panel (b) illustrates a tax imposed on sales of restaurant meals, for which both demand and supply are more elastic. As you can see, deadweight loss, the shaded triangle, is larger in panel (b) than in panel (a). Panel (a) Price of gasoline Excise tax Panel (b) Price of restaurant meal S Excise tax E S E D D Quantity of gasoline Quantity of restaurant meals 9. Assume that demand for gasoline is inelastic and supply is relatively elastic. The government imposes a sales tax on gasoline. The tax revenue is used to fund research into clean fuel alternatives to gasoline, which will improve the air we all breathe. a. Who bears more of the burden of this tax, consumers or producers? Show in a diagram who bears how much of the excess burden. b. Is this tax based on the benefits principle or the ability-to-pay principle? Explain. 9. a. The accompanying diagram shows an inelastic (relatively steep) demand curve for gasoline. The tax, whether imposed on consumers or producers, drives a wedge between the price paid by consumers, PC , and the price received by producers, PP. The burden of the tax is illustrated by the yellow and green areas A and B. Area A is the loss of consumer surplus—the burden of the tax that falls on consumers. Area B is the loss of producer surplus—the burden of the tax that falls on producers. Here, the burden is borne predominantly by consumers. Price PC S A B PP D Quantity b. Consumers who drive cars that use more gasoline pay most of the tax. If this tax were based on the benefits principle, the tax revenue would have to benefit those who pay most of the tax. However, everyone benefits equally from research into cleaner fuel, because of the improvement in air quality, so the tax is not based on the benefits principle. If this tax were based on the abilityto-pay principle, more of the tax would have to be paid by those who have a greater ability to pay. This would be true if cars that consume more gasoline were driven largely by higher-income individuals. To some extent this may be true: higher-income individuals drive larger cars, SUVs, and so on, and to the extent to which this is true, the tax is based on the ability-to-pay principle. However, a significant number of lower-income individuals drive old, fuelinefficient cars. To the extent to which this is true, the tax is not based on the ability-to-pay principle. 10. Assess the following four tax policies in terms of the benefits principle versus the ability-to-pay principle. a. A tax on gasoline that finances maintenance of state roads b. An 8% tax on imported goods valued in excess of $800 per household brought in on passenger flights c. Airline-flight landing fees that pay for air traffic control d. A reduction in the amount of income tax paid based on the number of dependent children in the household 10. a. This tax is based on the benefits principle, since the people who use the state’s roads will be the ones paying the gasoline tax. b. This tax is based on the ability-to-pay principle, since the people paying the tax will presumably be individuals who buy expensive items abroad and then import them on passenger flights. c. This tax is based on the benefits principle, since the airlines pay the landing fee and are also the beneficiary of air traffic control services. d. This reduction is based on the ability-to-pay principle. People who have more dependent children in their household will have higher expenses and so are less able to pay a given amount of income taxes, other things equal. 11. For this Discovering Data exercise, use FRED (fred.stlouisfed.org) to create a graph comparing the sources of government tax revenue for the United States over time. Under the tools tab select “Published Data Lists.” Find the list “Government Revenue by Source” and create a line graph that combines all three series. a. Using data from your graph, which source of government revenue is the largest? How have revenue sources changed over time? To measure the growth of government revenue since the start of the 2007 r­ ecession, follow these steps to format your graph as an index graph where 2007-12-01 = 100. i. Select “Edit Graph” and under “Edit Line 1” change “Units” to “Index (Scale value to 100 for chosen data).”        ii. In the box “U.S. recession” select “2007-12-01 Start” and then “Copy to All.” iii. In the graph frame change the time span from 2007-10-01 to today. b. Using the values in the graph, calculate the growth rate of each source of ­government revenue since 2007-12-01. Which has grown the fastest? Finally, edit your graph to compare how each source of revenue has changed as a percentage of total revenue. Complete the steps for each line: i. Under “Edit Line” change “Units” to “Billions of Dollars.”        ii. Under “Customize data” add the series “Federal Government Current Receipts” (code FGRECPT). iii. In the formula box enter “100*(a/b)” to express each series as a percentage of total tax receipts.     iv. In the graph frame change the time frame to “Max.” c. Use your graph to explain how the three sources of government revenue have changed over time and what happened to each source of revenue during the Great Recession. 11. a. Answers to this Discovering Data exercise can be found online. 12. You are advising the government on how to pay for national defense. There are two proposals for a tax system to fund national defense. Under both proposals, the tax base is an individual’s income. Under proposal A, all citizens pay exactly the same lump-sum tax, regardless of income. Under proposal B, individuals with higher incomes pay a greater proportion of their income in taxes. a. Is the tax in proposal A progressive, proportional, or regressive? What about the tax in proposal B? b. Is the tax in proposal A based on the ability-to-pay principle or on the benefits principle? What about the tax in proposal B? c. In terms of efficiency, which tax is better? Explain. 12. a. The tax in proposal A is regressive: since everyone pays the same dollar amount in taxes, higher-income individuals pay a lower percentage of their income in taxes. The tax in proposal B is progressive: higher-income individuals pay a higher percentage of their income in taxes. b. Every citizen benefits equally from national defense. The tax in proposal A is based on the benefits principle: since everyone benefits equally, everyone pays equally. The tax in proposal B is based on the ability-to-pay principle: higherincome individuals are able to pay more taxes, and under this proposal they do pay more taxes. c. In terms of efficiency, the lump-sum tax is better. The lump-sum tax creates a marginal tax rate of zero: once the tax is paid, every additional dollar earned is no longer taxed. Since it does not depend on people’s actions (how much income they choose to earn), it does not distort their incentives to earn income. The tax in proposal B has a higher marginal tax rate: each additional dollar of income earned is taxed. And the marginal tax rate is increasing: each additional dollar of income earned is taxed more than the previous d ­ ollar. This creates inefficiency, because it distorts the incentive to earn more income. 13. Each of the following tax proposals has income as the tax base. In each case, calculate the marginal tax rate for each level of income. Then calculate the percentage of income paid in taxes for an individual with a pre-tax income of $5,000 and for an individual with a pre-tax income of $40,000. Classify the tax as being proportional, progressive, or regressive. (Hint: You can calculate the marginal tax rate as the percentage of an additional $1 in income that is taxed away.) a. All income is taxed at 20%. b. All income up to $10,000 is tax-free. All income above $10,000 is taxed at a constant rate of 20%. c. All income between $0 and $10,000 is taxed at 10%. All income between $10,000 and $20,000 is taxed at 20%. All income higher than $20,000 is taxed at 30%. d. Each individual who earns more than $10,000 pays a lump-sum tax of $10,000. If the individual’s income is less than $10,000, that individual pays in taxes exactly what his or her income is. e. Of the four tax policies, which is likely to cause the worst incentive problems? Explain. 13. a. The marginal tax rate is 20% regardless of the taxpayer’s income level: on each additional $1 in income, individuals pay $0.20 in taxes, which is 20%. An individual with a pre-tax income of $5,000 would pay $5,000 × 20% = $1,000 in taxes; this is 20% of his or her income. An individual with a pre-tax income of $40,000 would pay $40,000 × 20% = $8,000 in taxes; this is 20% of his or her income. Since each individual pays the same percentage of income in taxes, regardless of income level, this tax is proportional. b. On income up to $10,000, there is a zero marginal tax rate: on each additional $1 of income in this tax bracket, individuals pay $0.00 in taxes, which is 0%. On income over $10,000, there is a 20% marginal tax rate: on each additional $1 of income in this tax bracket, individuals pay $0.20 in taxes, which is 20%. An individual with a pre-tax income of $5,000 would pay $5,000 × 0% = $0 in taxes; this is 0% of his or her income. An individual with a pre-tax income of $40,000 would pay $10,000 × 0% + $30,000 × 20% = $6,000 in taxes; this is $6,000/$40,000 × 100 = 15% of his or her income. This tax is progressive because the percentage of income paid in taxes rises as income rises. c. The marginal tax rate is 10% on the first $10,000 of income: on each additional $1 of income in this tax bracket, individuals pay $0.10 in taxes, which is 10%. It is 20% on the next $10,000 of income: on each additional $1 of income in this tax bracket, individuals pay $0.20 in taxes, which is 20%. It is 30% on all income above $20,000: on each additional $1 of income in this tax bracket, individuals pay $0.30 in taxes, which is 30%. An individual with a pre-tax income of $5,000 would pay $5,000 × 10% = $500 in taxes; this is 10% of his or her income. An individual with a pre-tax income of $40,000 would pay $10,000 × 10% + $10,000 × 20% + $20,000 × 30% = $9,000 in taxes; this is $9,000/$40,000 × 100 = 22.5% of his or her income. Again, this tax is progressive because the percentage of income paid in taxes rises as income rises. d. For individuals who earn less than $10,000, the marginal tax rate is 100%, since all additional income is taxed away. For those who earn more than $10,000, the marginal tax rate is zero: they pay the same amount of tax—$10,000—regardless of how much they earn over $10,000. An individual with a pre-tax income of $5,000 would pay $5,000 × 100% = $5,000 in taxes; this is 100% of his or her income. An individual with a pre-tax income of $40,000 would pay $10,000 in taxes; this is $10,000/$40,000 × 100 = 25% of his or her income. This tax policy is regressive because those with higher incomes pay a smaller share of their income in taxes than those with lower incomes. e. The tax policy in part d is likely to cause the worst incentive problems. People who work and make less than $10,000 will receive zero income after taxes are paid. As a result, there is no incentive to work. 14. In Transylvania the basic income tax system is fairly simple. The first 40,000 sylvers (the official currency of Transylvania) earned each year are free of income tax. Any additional income is taxed at a rate of 25%. In addition, every individual pays a social security tax, which is calculated as follows: all income up to 80,000 sylvers is taxed at an additional 20%, but there is no additional social security tax on income above 80,000 sylvers. a. Calculate the marginal tax rates (including income tax and social security tax) for Transylvanians with the following levels of income: 20,000 sylvers, 40,000 sylvers, and 80,000 sylvers. (Hint: You can calculate the marginal tax rate as the percentage of an additional 1 sylver in income that is taxed away.) b. Is the income tax in Transylvania progressive, regressive, or proportional? Is the social security tax progressive, regressive, or proportional? c. Which income group’s incentives are most adversely affected by the combined income and social security tax systems? 14. a. An individual who earns 20,000 sylvers pays no income tax but pays 20% of his or her income in social security tax. So the marginal tax rate is 20%. A n individual who earns 40,000 sylvers pays no income tax and pays 20% of his or her income in social security tax. But on an additional sylver (that is, on income above 40,000 sylvers) this individual pays a 45% tax (the basic income tax plus the social security tax). So the marginal tax rate is 45%. A n individual who earns 80,000 sylvers pays a marginal income tax rate of 25% and 20% in social security tax. But on an additional sylver (that is, on income above 80,000 sylvers), this individual pays only 25% (the income tax rate) because there is no social security tax on income over 80,000 sylvers. So this individual’s marginal tax rate is 25%. b. The Transylvanian income tax system is progressive because the percentage of income paid in income taxes rises as income rises. But the social security tax system is a mix of proportional and regressive because the percentage of income paid in social security tax is constant at 20% up to an income of 80,000 sylvers, and then it falls to zero as income increases further. This makes the social security tax regressive overall. c. In this system, incentive problems are worst for middle-income individuals (between 40,000 and 80,000 sylvers) because they have the highest marginal tax rate, 45%. 15. You work for the Council of Economic Advisers, providing economic advice to the White House. The president wants to overhaul the income tax system and asks your advice. Suppose that the current income tax system consists of a proportional tax of 10% on all income and that there is one person in the country who earns $110 million; everyone else earns less than $100 million. The president proposes a tax cut targeted at the very rich so that the new tax system would consist of a proportional tax of 10% on all income up to $100 million and a marginal tax rate of 0% (no tax) on income above $100 million. You are asked to evaluate this tax proposal. a. For incomes of $100 million or less, is this proposed tax system p ­ rogressive, regressive, or proportional? For incomes of more than $100 million? Explain. b. Would this tax system create more or less tax revenue, other things equal? Is this tax system more or less efficient than the current tax system? Explain. 15. a. This tax system is proportional up to an income of $100 million. Above $100 million, the tax is regressive, since higher-income taxpayers pay a smaller ­percentage of their income in taxes. For instance, the individual with income of $110 million pays $100 million × 10% = $10 million in taxes, which is $10 million/$110 million × 100 = 9% of his or her income in taxes. But an ­individual with an even higher income, say $200 million, would pay $100 ­million × 10% = $10 million in taxes, which is $10 million/$200 million × 100 = 5% of his or her income in taxes. b. This tax system would raise almost the same amount of tax revenue, since for all individuals, except for the one richest individual, it is identical to the current tax system. The richest individual pays $10 million in taxes, except the new tax system now creates an incentive for that individual to work to raise his or her income: an additional dollar of income is now worth exactly one additional dollar. Under the current system, an additional dollar of income for the top earner would only be worth an additional 90 cents. So this tax system is more efficient than the current tax system. WORK IT OUT Interactive step-by-step help with solving this problem can be found online. 16. The U.S. government wants to help the American auto industry compete against foreign automakers that sell trucks in the United States. It can do this by imposing an excise tax on each foreign truck sold in the United States. The hypothetical pre-tax demand and supply schedules for imported trucks are given in this table. Price of imported truck Quantity of imported trucks (thousands) Quantity demanded Quantity supplied $32,000 100 400 31,000 200 350 30,000 300 300 29,000 400 250 28,000 500 200 27,000 600 150 a. In the absence of government interference, what is the equilibrium price of an imported truck? The equilibrium quantity? Illustrate with a diagram. b. Assume that the government imposes an excise tax of $3,000 per imported truck. Illustrate the effect of this excise tax in your diagram from part a. How many imported trucks are now purchased and at what price? How much does the foreign automaker receive per truck? c. Calculate the government revenue raised by the excise tax in part b. Illustrate it on your diagram. d. How does the excise tax on imported trucks benefit American automakers? Whom does it hurt? How does inefficiency arise from this government policy? 16. a. The equilibrium price without government interference is $30,000 and the equilibrium quantity is 300,000, as shown by point E in the accompanying diagram. Price of imported truck S $32,000 Excise tax = $3,000 per truck 31,000 E 30,000 29,000 28,000 27,000 0 D 100 200 300 400 500 600 Quantity of imported trucks (thousands) b. The effect of the excise tax is illustrated in the diagram: a tax of $3,000 per truck puts a wedge between the price paid by consumers, or the demand price ($31,000), and the price received by producers, or the supply price ($28,000). The quantity bought and sold is 200,000 trucks. The foreign automaker receives $28,000 per truck (after tax). c. Since 200,000 trucks are sold, and the government earns a tax of $3,000 on each truck, the total tax revenue is 200,000 × $3,000 = $600 million. This is the shaded area in the diagram. d. The excise tax leads to a rise in the price of imported trucks. Since American trucks are substitutes for imported trucks, the effect of the tax is to increase the demand for American-made trucks, which leads to a higher price for them. As a result, buyers of both domestic and foreign trucks pay higher prices because of the tax on foreign trucks. Inefficiency arises because some mutually beneficial transactions no longer occur due to the higher prices for trucks caused by the tax. International Trade Chapter 1. Both Canada and the United States produce lumber and footballs with constant opportunity costs. The United States can produce either 10 tons of lumber and no footballs, or 1,000 footballs and no lumber, or any combination in between. Canada can produce either 8 tons of lumber and no footballs, or 400 footballs and no lumber, or any combination in between. a. Draw the U.S. and Canadian production possibility frontiers in two separate diagrams, with footballs on the horizontal axis and lumber on the vertical axis. b. In autarky, if the United States wants to consume 500 footballs, how much lumber can it consume at most? Label this point A in your diagram. Similarly, if Canada wants to consume 1 ton of lumber, how many footballs can it consume in autarky? Label this point C in your diagram. c. Which country has the absolute advantage in lumber production? d. Which country has the comparative advantage in lumber production? Suppose each country specializes in the good in which it has the comparative advantage, and there is trade. e. How many footballs does the United States produce? How much lumber does Canada produce? f. Is it possible for the United States to consume 500 footballs and 7 tons of lumber? Label this point B in your diagram. Is it possible for Canada at the same time to consume 500 footballs and 1 ton of lumber? Label this point D in your diagram. 1. a. The two accompanying diagrams illustrate the U.S. and Canadian production possibility frontiers. Quantity of lumber (tons) 10 7 5 (a) U.S. Production Possibility Frontier 8 B Canada PPF A U.S. PPF 0 Quantity of lumber (tons) (b) Canadian Production Possibility Frontier 500 1,000 Quantity of footballs 1 0 C D 350 400 500 Quantity of footballs b. If the United States wants to consume 500 footballs, in autarky it can at most consume 5 tons of lumber, as indicated by point A in panel (a) of the diagram. And if Canada wants to consume 1 ton of lumber, it can at most consume 350 footballs in autarky, as shown by point C in panel (b). c. The United States can produce at most 10 tons of lumber, and Canada can produce at most 8 tons. So the United States has the absolute advantage in lumber production. 8 d. In the United States, producing 1 additional ton of lumber means forgoing production of 100 footballs: the opportunity cost of 1 ton of lumber is 100 footballs. In Canada, the opportunity cost of 1 ton of lumber is 50 footballs. Since the opportunity cost of lumber production in Canada is lower, Canada has the comparative advantage in lumber production. e. If there is trade, the United States will specialize in the production of footballs and produce 1,000 footballs. Canada will specialize in lumber production and produce 8 tons of lumber. f. With trade, it is possible for the United States to consume 500 footballs and 7 tons of lumber. This is shown by point B in the diagram. That leaves exactly 500 footballs and 1 ton of lumber to be consumed by Canada, shown by point D. 2. For each of the following trade relationships, explain the likely source of the comparative advantage of each of the exporting countries. a. The United States exports software to Venezuela, and Venezuela exports oil to the United States. b. The United States exports airplanes to China, and China exports clothing to the United States. c. The United States exports wheat to Colombia, and Colombia exports coffee to the United States. 2. a. The United States has the comparative advantage in software production because of a factor endowment: a relatively large supply of human capital. Venezuela has the comparative advantage in oil production because of a factor endowment: large oil reserves. b. The United States has the comparative advantage in airplane production because of a factor endowment: it has a relatively large supply of the human capital needed to produce airplanes. China has the comparative advantage in clothing production because of a factor endowment: it has a relatively large supply of unskilled labor. c. The United States has the comparative advantage in wheat production because of an advantage in climate: it has a climate suitable for growing wheat. Colombia has the comparative advantage in coffee production because of an advantage in climate: it has a climate suitable for growing coffee. 3. According to data from the U.S. Census Bureau, since 2000, the value of U.S. imports of men’s and boy’s apparel from China has more than tripled from a relatively small $244 million in 2000 to $926 million in 2014. What prediction does the Heckscher–Ohlin model make about the wages received by labor in China? 3. As trade increases, the Heckscher–Ohlin model predicts that prices of factors that are abundantly available in a country will rise. In other words, the model predicts that the wages received by labor in China would have risen between 2000 and 2014. (Is this really true? According to China’s National Bureau of Statistics, the average Chinese worker’s wage in the private sector rose from 9,371 yuan in 2000 to 36,390 yuan in 2014, the latest year for which data were available at the time of writing. Almost none of this increase in wages was due to inflation: between 2000 and 2014, China experienced very little inflation.) 4. Shoes are labor-intensive and satellites are capital-intensive to produce. The United States has abundant capital. China has abundant labor. According to the Heckscher–Ohlin model, which good will China export? Which good will the United States export? In the United States, what will happen to the price of labor (the wage) and to the price of capital? 4. The Heckscher–Ohlin model predicts that a country will have a comparative advantage in the good whose production is intensive in the factor the country has abundantly available: the United States has the comparative ­advantage in satellite production, and China has the comparative advantage in shoe ­production. So the United States will export satellites, and China will export shoes. In the United States, demand for capital increases, raising the price of capital, but the demand for labor decreases, lowering the wage. 5. Before the North American Free Trade Agreement (NAFTA) gradually eliminated import tariffs on goods, the autarky price of tomatoes in Mexico was below the world price and in the United States was above the world price. Similarly, the autarky price of poultry in Mexico was above the world price and in the United States was below the world price. Draw diagrams with domestic supply and demand curves for each country and each of the two goods. (You will need to draw four diagrams, total.) As a result of NAFTA, the United States now imports tomatoes from Mexico and the United States now exports poultry to Mexico. How would you expect the following groups to be affected? a. Mexican and U.S. consumers of tomatoes. Illustrate the effect on consumer surplus in your diagram. b. Mexican and U.S. producers of tomatoes. Illustrate the effect on producer ­surplus in your diagram. c. Mexican and U.S. tomato workers. d. Mexican and U.S. consumers of poultry. Illustrate the effect on consumer ­surplus in your diagram. e. Mexican and U.S. producers of poultry. Illustrate the effect on producer ­surplus in your diagram. f. Mexican and U.S. poultry workers. 5. The four accompanying diagrams illustrate the U.S. and Mexican domestic demand and supply curves. Price of tomatoes (a) U.S. Tomato Imports Domestic supply Price of tomatoes (b) Mexican Tomato Exports Domestic supply PUS A B PW PW X W Domestic demand Q1 QUS C1 PM Domestic demand Quantity of tomatoes C2 Imports Q2 Quantity of tomatoes Exports (c) U.S. Poultry Exports Price of poultry QM Domestic supply Price of poultry (d) Mexican Poultry Imports Domestic supply PM Y PW D C PUS Z PW Domestic demand Domestic demand C3 QUS Q3 Exports Quantity of poultry Q4 QM Imports C4 Quantity of poultry a. As shown in panel (b), consumer surplus decreases in Mexico by the size of area W as the price rises from PM to PW. As shown in panel (a), consumer surplus increases in the United States by the size of the area A + B as the price falls from PUS to PW. b. As shown in panel (a), production of tomatoes decreases in the United States from QUS to Q1; producer surplus decreases by area A. As shown in panel (b), production of tomatoes increases in Mexico from QM to Q2, so producer surplus increases by areas W + X. c. As production of tomatoes decreases in the United States, the demand for U.S. tomato workers falls and so the wages of U.S. tomato workers fall. In Mexico, as the production of tomatoes increases, the wages of Mexican tomato workers rise. d. As shown in panel (d), consumer surplus increases in Mexico by the size of areas Y + Z as the price falls from PM to PW. As shown in panel (c), consumer surplus decreases in the United States by the size of area C as the price rises from PUS to PW. e. As shown in panel (d), production of poultry decreases in Mexico, from QM to Q4; so producer surplus in Mexico decreases by area Y. As shown in panel (c), U.S. production of poultry increases from QUS to Q3; so producer surplus in the United States increases by areas C + D. f. As production of poultry increases in the United States, the demand for poultry workers rises and so the wages of poultry workers rise. In Mexico, as the production of poultry decreases, the wages of poultry workers fall. 6. The accompanying table indicates the U.S. domestic demand schedule and domestic supply schedule for commercial jet airplanes. Suppose that the world price of a commercial jet airplane is $100 million. Price of jet (millions) Quantity of jets demanded Quantity of jets supplied $120 100 1,000 110 150 900 100 200 800 90 250 700 80 300 600 70 350 500 60 400 400 50 450 300 40 500 200 a. In autarky, how many commercial jet airplanes does the United States ­produce, and at what price are they bought and sold? b. With trade, what will the price for commercial jet airplanes be? Will the United States import or export airplanes? How many? 6. a. In autarky, the equilibrium price will be $60 million, and 400 airplanes will be bought and sold at that price. b. When there is trade, the price rises to the world price of $100 million. At that price, the domestic quantity supplied is 800, and the domestic quantity demanded is 200. So 600 airplanes are exported. 7. The accompanying table shows the U.S. domestic demand schedule and domestic supply schedule for oranges. Suppose that the world price of oranges is $0.30 per orange. Price of orange Quantity of oranges demanded (thousands) Quantity of oranges supplied (thousands) $1.00 2 11 0.90 4 10 0.80 6 9 0.70 8 8 0.60 10 7 0.50 12 6 0.40 14 5 0.30 16 4 0.20 18 3 a. Draw the U.S. domestic supply curve and domestic demand curve. b. With free trade, how many oranges will the United States import or export? Suppose that the U.S. government imposes a tariff on oranges of $0.20 per orange. c. How many oranges will the United States import or export after introduction of the tariff? d. In your diagram, shade the gain or loss to the economy as a whole from the introduction of this tariff. 7. a. The U.S. domestic supply and demand curves are illustrated in the accompanying diagram. Price of orange Domestic supply $0.70 0.50 0.30 0 Domestic demand 4 6 8 12 Imports with tariff 16 Quantity of oranges (thousands) Imports without tariff b. With free trade, the price will be the world price, $0.30, the domestic quantity demanded will be 16,000 oranges, and the domestic quantity supplied will be 4,000 oranges. So the United States will import 12,000 oranges. c. With the tariff, the domestic price will rise to $0.50. At that price, the domestic quantity demanded will exceed the domestic quantity supplied by 6,000. So the United States will import 6,000 oranges. d. The shaded areas indicate the deadweight loss to the economy as a whole due to the tariff. 8. The U.S. domestic demand schedule and domestic supply schedule for oranges was given in Problem 7. Suppose that the world price of oranges is $0.30. The United States introduces an import quota of 3,000 oranges and assigns the quota rents to foreign orange exporters. a. Draw the domestic demand and supply curves. b. What will the domestic price of oranges be after introduction of the quota? c. Illustrate the area representing the quota rent on your graph. What is the value of the quota rents that foreign exporters of oranges receive? 8. a. The domestic demand and domestic supply curves are shown in the accompanying diagram. Price of orange Domestic supply Quota rent $0.60 0.30 0 Domestic demand 4 7 10 Imports with quota 16 Quantity of oranges (thousands) Imports without quota b. After introduction of the quota, instead of importing 16,000 − 4,000 = 12,000 oranges, the United States will import only 3,000 oranges. The price will rise to $0.60, the price at which the domestic quantity demanded exceeds the domestic quantity supplied by exactly 3,000 oranges. c. The foreign exporters of oranges receive quota rent of $0.30 × 3,000 = $900. The area of the shaded square represents the quota rent. 9. The Observatory of Economic Complexity (OEC) is a data visualization that models international trade data among countries. Go to the website at atlas.media.mit.edu to answer the following questions. a. Start by selecting “Countries” and enter “United States” in the search bar. In 2014, what was the largest exported good (in dollars) for the United States? What was the value of exports for “Planes, Helicopters, and/or Spacecraft”? What was the largest imported good for the United States? b. Repeat the steps above for Brazil. In 2014, what was the largest exported good for Brazil? What was the value of exports for “Planes, Helicopters, and/or Spacecraft”? What was the largest imported good for Brazil? c. On the left sidebar click on the link “Explore on Visualization Page.” On the new page, in the left sidebar select “Exports,” under “Country” select “Brazil,” under “Partner” select “United States,” and then “Build Visualization.” What is the total value of Brazilian exports to the United States? What is Brazil’s largest exported good (in dollars) compared to the United States? What type of goods does Brazil generally export to the United States? What is the value of exports related to “Planes, Helicopters, and/or Spacecraft”? d. Now repeat the steps from part c for exports from the United States to Brazil. Change “Country” to “United States,” change “Partner” to “Brazil,” and select “Build Visualization.” What is the total value of exports from the United States to Brazil? What is the United States’ largest export (in dollars) to Brazil? What types of goods does the United States export to Brazil? What was the value of exports related to “Planes, Helicopters, and/or Spacecraft”? 9. a. In 2014, “Refined Petroleum” accounted for approximately 7.1% (or $103 billion) of all U.S. exports, the largest exported good for the United States. The United States exported $53.2 billion in “Planes, Helicopters, and/ or Spacecraft,” which was approximately 3.7% of all U.S. exports. The largest imported good for the United States was “Crude Petroleum.” b. In 2014, “Iron Ore” was approximately 12% (or $26.9 billion) of all Brazilian exports, and its largest exported good. Brazil exported $3.9 billion in “Planes, Helicopters, and/or Spacecraft,” which was approximately 1.7% of all Brazilian exports. The largest imported good for Brazil was “Refined Petroleum.” c. Brazil exported $27.3 billion of goods to the United States in 2014. “Crude Petroleum” was the largest exported item at 14% (or $3.85 billion) of all ­Brazilian exports to the United States. In general, Brazil exported “Mineral products” and “Metals” to the United States. Not surprisingly, “Planes, ­Helicopters, and/ or Spacecraft” was the second largest exported item from Brazil to the United States, making up 7.2% (or $1.98 billion) of all Brazilian exports to the United States. Embraer, located in Brazil, manufactures a popular small regional jet used by commercial airlines and private plane owners througout the world. d. The United States exported $35.1 billion of goods to Brazil in 2014 and “Refined Petroleum” was the largest exported item at 14% (or $5.05 billion) of all U.S. exports to Brazil. In general, the United States exported “Machines” and “Chemical Products” to Brazil. “Planes, Helicopters, and/or Spacecraft” made up 1.7% (or $589 million) of exports from the United States to Brazil. 10. Comparative advantage creates an opportunity for less productive economies like Bangladesh to trade with more productive economies like the United States. Using the OEC website from Problem 9, how much did Bangladesh export to the United States? What was its largest export to the United States? In general, what type of goods did Bangladesh export to the United States? 10. In 2014, Bangladesh exported $5.23 billion to the United States, and 28% of those exports were in “Non-Knit Men’s Suits.” Nearly all of the exports, $4.9 billion, to the United States were textiles. This confirms that relative to the United States, Bangladesh had a comparative advantage in clothing. 11. Once again, using the OEC website from Problems 9 and 10, identify which country has a comparative advantage for each of the following goods. For each good, include the country’s share of global exports and the total dollar value of that share. a. Computers b. Maple syrup c. Soybeans d. Cocoa beans e. Beer 11. a. China was the largest exporter of computers. Therefore China has a comparative advantage in computers. China exported 53% (or $209 billion) of all global computer exports. b. Canada was the largest exporter of maple syrup. Therefore Canada has a comparative advantage in maple syrup. Canada exported 84% ($308 million) of all global maple syrup exports. c. The United States and Brazil were the two largest exporters of soybeans. Therefore the United States and Brazil have a comparative advantage in soybeans. The United States exported 41% (or $24.4 billion) and Brazil exported 40% (or $23.6 billion) of all global soybean exports. d. Côte d’Ivoire (The Ivory Coast) was the largest exporter of cocoa beans. Therefore, the Ivory Coast has a comparative advantage in cocoa beans. It exported 37% (or $3.58 billion) of all global cocoa bean exports. e. Mexico was the world’s largest beer exporter, accounting for 22% (or $2.91 billion) of all global beer exports. Therefore Mexico has a comparative advantage in beer production. 12. Over the past five years the United States has become the world’s largest producer of natural gas. But gas producers have struggled to find methods to liquefy natural gas so that it can be exported across the Atlantic. Enter Cheniere Energy, a Houston-based natural gas company that has developed a natural gas export terminal located on the Sabine Pass leading into the Gulf of Mexico. The terminal will give U.S. companies access to markets all over the world. a. Explain how the development of a natural gas export terminal will affect the market for natural gas in the United States. b. Assuming natural gas prices are $3.00 per BTU, draw a graph to illustrate the effect of an export terminal on the demand for natural gas in the United States. Explain your findings. c. Assuming natural gas prices in Europe are $6.00 per BTU, draw a diagram to illustrate how the development of a natural gas terminal in the United States will affect supply and demand in the natural gas market for Europe. Explain your findings. d. How will the exporting of natural gas from the United States to Europe affect consumers and producers in both places? 12. a. As the United States is able to liquefy and export natural gas, demand for natural gas produced in the United States will increase. This will increase both the price and quantity of natural gas. b. The following figure shows the market for natural gas in the United States. Being able to export natural gas will increase the number of buyers. This is shown by shifting the demand line right from D1 to D2. Price will increase from P1 or $3.00 to P2 and quantity will increase from Q1 to Q2. Price of natural gas in the United States Supply E2 P2 $3.00 P1 E1 D1 Q1 Q2 D2 Quantity of natural gas in the United States c. The following figure shows that the demand for natural gas will remain unchanged. But as the United States is able to export natural gas into European markets, the supply of natural gas will increase. This will cause price to decrease from P1 or $6.00 to P2 and quantity to increase from Q1 to Q2. Price of natural gas in Europe $6.00 S1 S2 E1 P1 P2 E2 Demand Q1 Q2 Quantity of natural gas in Europe d. Exporting natural gas from the United States to Europe will cause the price to increase for U.S. consumers, who will be made worse off. But U.S. producers of natural gas will sell a greater quantity of gas at a higher price, making them better off. European consumers will buy more natural gas at a lower price. They will be better off. But European producers will receive a lower price, so European producers will be worse off. 13. For this Discovering Data exercise, use FRED (fred.stlouisfed.org) to create a graph comparing exports from California, Florida, Michigan, Pennsylvania, and Washington to China. In the search bar enter “Value of exports to China from California” and select the subsequent series. Follow the steps below to add the remaining states: i. Select “Edit Graph,” under “Add Line” enter “Value of exports to China from Florida,” then select “Add data series.” ii. Repeat step i for Michigan, Pennsylvania, and Washington. iii. In the date bar start the graph with 2002-01-01. a. As of 2012, which two states exported the most goods to China? What were the dollar values of those exports? Which three states exported the least to China? b. How did exports to China change from 2002 to 2012? Construct a table to show the change in the value of exports from 2002 to 2012 for each state. Follow the steps below to edit your graph and calculate the percent of exports to China relative to the total exports for each state: i. Select “Edit Graph” and under “Edit Lines” select “Edit Line 1.” ii. Under the heading “Customize Data” add “Value of Exports to World from California” (hint: make sure the states match) and add the series. iii. In the “Formula box” enter 100*(a/b) to create the percent term. iv.  Repeat steps i through iii for the remaining states. c. As a percent of total exports, rank the states in order of most to fewest exports. d. Washington State’s largest exports to China are airplanes from Boeing, licenses for the use of Microsoft products, and the agricultural products wheat, apples, and hops. Microsoft and Boeing produce unique products at a relatively high price but many other states produce wheat, apples, and hops. The other states export largely regular goods to China. How does this situation explain the pattern of exports to China across the states? 13. Answers to this Discovering Data exercise can be found online. 14. The accompanying diagram illustrates the U.S. domestic demand curve and domestic supply curve for beef. Price of beef Domestic supply PT PW A B C D Domestic demand QS QST QDT QD Quantity of beef The world price of beef is PW. The United States currently imposes an import tariff on beef, so the price of beef is PT. Congress decides to eliminate the tariff. In terms of the areas marked in the diagram, answer the following questions. a. With the elimination of the tariff what is the gain/loss in consumer surplus? b. With the elimination of the tariff what is the gain/loss in producer surplus? c. With the elimination of the tariff what is the gain/loss to the government? d. With the elimination of the tariff what is the gain/loss to the economy as a whole? 14. a. As the price falls from PT to PW, consumer surplus increases by areas A + B + C + D. b. As the price falls, producer surplus decreases by area A. c. As the tariff is eliminated, the government loses revenue of area C, which is the amount of imports under the tariff (QDT - QST) times the tariff. d. The gain to the economy as a whole is the gain to consumers minus the loss to producers minus the loss to the government: A + B + C + D - A - C = B + D. 15. As the United States has opened up to trade, it has lost many of its low-skill manufacturing jobs, but it has gained jobs in high-skill industries, such as the software industry. Explain whether the United States as a whole has been made better off by trade. 15. As the United States has opened up to trade, it has specialized in producing goods that use high-skill labor (such as software design) in which it has a comparative advantage, and it has allowed other countries to specialize in producing low-skill manufactured goods in which they have the comparative advantage. As a result, the country has lost low-skill manufacturing jobs (and the wage to low-skill workers has fallen), and it has gained jobs in high-skill industries (and the wage to high-skill workers has risen). That is, demand for labor in exporting industries has risen, and demand for labor in import-competing industries has fallen, as the Heckscher–Ohlin model predicts. But as a result of trade, the United States can now consume more of all goods than before. That is, overall the economy is better off, so the gains to high-skill workers outweigh the losses to low-skill workers. 16. The United States is highly protective of its agricultural (food) industry, imposing import tariffs, and sometimes quotas, on imports of agricultural goods. This chapter presented three arguments for trade protection. For each argument, discuss whether it is a valid justification for trade protection of U.S. agricultural products. 16. The three arguments for trade protection are the national security, job creation, and infant industry arguments. Agriculture is not an infant industry, so this argument does not apply. Some argument can be made that agricultural products are necessary for national security: if we depended completely on imports for our agricultural goods, we would be vulnerable if our trading partners cut off our imports. And protecting agriculture does not create jobs. It does protect farming jobs; but it is likely that if agriculture lost its protection from imports, those workers could find other jobs in industries that expand due to lower food costs (such as the restaurant industry). The rationale for protecting agricultural markets from imports must lie elsewhere—in the political power of the farm lobby. 17. In World Trade Organization (WTO) negotiations, if a country agrees to reduce trade barriers (tariffs or quotas), it usually refers to this as a concession to other countries. Do you think that this terminology is appropriate? 17. The word concession implies that when a country lowers its trade barriers, it is giving up something to other countries. As discussed in this chapter, free trade is beneficial to all countries, including the country that lowers its trade barriers. In fact, even if no other country does so, the country that does lower its trade barriers still benefits from trade. By allowing more international trade, each country’s economy simply gains overall. So the terminology concession is not appropriate. 18. Producers in import-competing industries often make the following argument: “Other countries have an advantage in production of certain goods purely because workers abroad are paid lower wages. In fact, American workers are much more productive than foreign workers. So import-competing industries need to be protected.” Is this a valid argument? Explain your answer. 18. Even if American workers were better at producing everything than are foreign workers (that is, even if America had the absolute advantage in everything), this does not mean that the United States should restrict trade. What matters for trade is who has the comparative advantage. In fact, other countries will have a comparative advantage in some good or service, and specialization and trade will mean improvements in the welfare of both countries. Claiming that other countries have an advantage only because labor is so cheap relies on the pauper labor fallacy. WORK IT OUT Interactive step-by-step help with solving this problem can be found online. 19. Assume Saudi Arabia and the United States face the production possibilities for oil and cars shown in the accompanying table. Saudi Arabia Quantity of oil (millions of barrels) United States Quantity of cars (millions) Quantity of oil (millions of barrels) Quantity of cars (millions) 0 4 0 10.0 200 3 100 7.5 400 2 200 5.0 600 1 300 2.5 800 0 400 0 a. What is the opportunity cost of producing a car in Saudi Arabia? In the United States? What is the opportunity cost of producing a barrel of oil in Saudi Arabia? In the United States? b. Which country has the comparative advantage in producing oil? In ­producing cars? c. Suppose that in autarky, Saudi Arabia produces 200 million barrels of oil and 3 million cars; and suppose that the United States produces 300 million barrels of oil and 2.5 million cars. Without trade, can Saudi Arabia produce more oil and more cars? Without trade, can the United States produce more oil and more cars? Suppose now that each country specializes in the good in which it has the comparative advantage, and the two countries trade. Also assume that for each country the value of imports must equal the value of exports. d. What is the total quantity of oil produced? What is the total quantity of cars produced? e. Is it possible for Saudi Arabia to consume 400 million barrels of oil and 5 million cars and for the United States to consume 400 million barrels of oil and 5 million cars? f. Suppose that, in fact, Saudi Arabia consumes 300 million barrels of oil and 4 million cars and the United States consumes 500 million barrels of oil and 6 million cars. How many barrels of oil does the United States import? How many cars does the United States export? Suppose a car costs $10,000 on the world market. How much, then, does a barrel of oil cost on the world market? 19. a. In Saudi Arabia, 1 million cars can be produced by giving up production of 200 million barrels of oil. So the opportunity cost of 1 car in Saudi Arabia is 200 barrels of oil. The opportunity cost of 2.5 million cars in the United States is 100 million barrels of oil, making the opportunity cost of 1 car equal to 100 million/2.5 million = 40 barrels of oil. The opportunity cost of 1 barrel of oil in Saudi Arabia is 0.005 of a car (equal to 1 car divided by 200 barrels of oil). The opportunity cost of 1 barrel of oil in the United States is 0.025 of a car (equal to 1 car divided by 40 barrels of oil). b. Since the opportunity cost of producing oil is lower in Saudi Arabia, it has the comparative advantage in oil production. And since the opportunity cost of producing cars is lower in the United States, it has the comparative advantage in car production. c. In autarky, Saudi Arabia cannot produce both more oil and more cars. If Saudi Arabia produces 200 million barrels of oil and 3 million cars, it is on its production possibility frontier. This means that it can produce more oil only if it produces fewer cars. The same is true for the United States. d. If each country specializes, Saudi Arabia will produce 800 million barrels of oil and the United States will produce 10 million cars. e. It is possible for Saudi Arabia to consume 400 million barrels of oil and for the United States to consume 400 million barrels of oil (for a total of 800 million barrels). And it is possible for Saudi Arabia to consume 5 million cars and for the United States to consume 5 million cars (for a total of 10 million cars). f. The United States imports 500 million barrels of oil and exports 4 million cars. That is, each car trades for 125 barrels of oil. If a car costs $10,000 on the world market, then a barrel of oil costs $10,000/125 = $80. Decision Making by Individuals and Firms 1. Jackie owns and operates a website design business. To keep up with new technology, she spends $5,000 per year upgrading her computer equipment. She runs the business out of a room in her home. If she didn’t use the room as her business office, she could rent it out for $2,000 per year. Jackie knows that if she didn’t run her own business, she could return to her previous job at a large software company that would pay her a salary of $60,000 per year. Jackie has no other expenses. a. How much total revenue does Jackie need to make in order to break even in the eyes of her accountant? That is, how much total revenue would give Jackie an accounting profit of just zero? b. How much total revenue does Jackie need to make in order for her to want to remain self-employed? That is, how much total revenue would give Jackie an economic profit of just zero? 1. a. Jackie’s accounting profit is: Total revenue − $5,000. (The only cost that her accountant would add into the accounting profit calculation is the cost of upgrading her computer equipment.) For her accounting profit to be just equal to zero, her total revenue would have to be $5,000. b. Jackie’s economic profit is: Total revenue − $5,000 − $2,000 − $60,000 = Total revenue − $67,000. (Cost of equipment upgrade, the opportunity cost of not renting out the room, and the opportunity cost of Jackie’s time are all costs that figure into the calculation of economic profit.) For this to be just equal to zero, Jackie’s total revenue would have to be $67,000. 2. You own and operate a bike store. Each year, you receive revenue of $200,000 from your bike sales, and it costs you $100,000 to obtain the bikes. In addition, you pay $20,000 for electricity, taxes, and other expenses per year. Instead of running the bike store, you could become an accountant and receive a yearly ­salary of $40,000. A large clothing retail chain wants to expand and offers to rent the store from you for $50,000 per year. How do you explain to your friends that despite making a profit, it is too costly for you to continue running your store? 2. Your yearly accounting profit is:     $200,000 (total revenue) − $100,000 (cost of bikes) −     $20,000 (electricity, taxes, and other expenses)       $80,000 (accounting profit) But not renting the store to the retail chain is an opportunity cost, and not being able to make $40,000 as an accountant is also an opportunity cost, so your yearly economic profit is:          $80,000 (accounting profit) −       $40,000 (opportunity cost of your time) −      $50,000 (opportunity cost of not renting the store) −        $10,000 (economic profit) So although you make an accounting profit each year, you would be better off renting the store to the large chain and becoming an accountant yourself, since your opportunity cost of continuing to run your own store is too high. Chapter 9 3. Suppose you have just paid a nonrefundable fee of $1,000 for your meal plan for this academic term. This allows you to eat dinner in the cafeteria every evening. a. You are offered a part-time job in a restaurant where you can eat for free each evening. Your parents say that you should eat dinner in the cafeteria anyway, since you have already paid for those meals. Are your parents right? Explain why or why not. b. You are offered a part-time job in a different restaurant where, rather than being able to eat for free, you receive only a large discount on your meals. Each meal there will cost you $2; if you eat there each evening this semester, it will add up to $200. Your roommate says that you should eat in the restaurant since it costs less than the $1,000 that you paid for the meal plan. Is your roommate right? Explain why or why not. 3. a. Your parents are wrong. They are making the mistake of considering sunk costs. Since the $1,000 that you have already paid for the meal plan is nonrefundable, it should not enter into your decision making now. Your decision of where to eat should depend only on those costs and benefits that are affected by your decision. Since both the cafeteria meals and the restaurant meals are free, you should choose to eat where the benefit to you (convenience, quality of food, and so on) is greater. b. Your roommate is wrong. Since the $1,000 that you have already paid for the meal plan is nonrefundable, it should not enter into your decision making now. It is a sunk cost. In deciding where to eat, you should weigh the benefit and cost of eating in the restaurant (where each meal costs $2) against the benefit and cost of eating in the cafeteria (where meals are free). You may decide to eat in the restaurant, but only if that gives you a benefit that is at least $2 greater than the benefit you get from eating in the cafeteria. 4. You have bought a $10 ticket in advance for the college soccer game, a ticket that cannot be resold. You know that going to the soccer game will give you a benefit equal to $20. After you have bought the ticket, you hear that there will be a professional baseball post-season game at the same time. Tickets to the baseball game cost $20, and you know that going to the baseball game will give you a benefit equal to $35. You tell your friends the following: “If I had known about the baseball game before buying the ticket to the soccer game, I would have gone to the baseball game instead. But now that I already have the ticket to the soccer game, it’s better for me to just go to the soccer game.” Are you making the correct decision? Justify your answer by calculating the benefits and costs of your decision. 4. Yes, you are making the correct decision. If you had known about the baseball game before buying the ticket to the soccer game, your decision would have been as follows: Go to the soccer game    $20 (benefit) −$ 10 (cost of ticket)      $ 10 Go to the baseball game $35 (benefit) −$20 (cost of ticket) $15 Since the baseball game would have given you the greater total profit, you should have gone to the baseball game. But after you have already bought the ticket to the soccer game, your decision is different: the ticket to the soccer game (since it cannot be resold) is now a sunk cost, and you should no longer take it into account. Your decision now looks as follows: Go to the soccer game    $20 (benefit) Go to the baseball game $35 (benefit) −$20 (cost of ticket)      $ 20 $15 So, since you had already bought the ticket to the soccer game before you heard about the baseball game, it is optimal for you to go to the soccer game. 5. Amy, Bill, and Carla all mow lawns for money. Each of them operates a different lawn mower. The accompanying table shows the total cost to Amy, Bill, and Carla of mowing lawns. Quantity of lawns mowed Amy’s total cost Bill’s total cost Carla’s total cost 0 $0 $0 $0 1 20 10 2 2 35 20 7 3 45 30 17 4 50 40 32 5 52 50 52 6 53 60 82 a. Calculate Amy’s, Bill’s, and Carla’s marginal costs, and draw each of their marginal cost curves. b. Who has increasing marginal cost, who has decreasing marginal cost, and who has constant marginal cost? 5. a. The accompanying table shows Amy’s, Bill’s, and Carla’s marginal costs. Quantity of lawns mowed Amy’s total cost 0 $0 1 20 2 35 Amy’s marginal cost of lawn mowed Bill’s total cost $0 $20 $10 10 10 50 5 52 6 53 5 7 10 30 5 4 $2 2 20 45 Carla’s total cost 10 17 10 40 2 15 32 10 50 1 20 52 10 60 Carla’s marginal cost of lawn mowed $0 10 15 3 Bill’s marginal cost of lawn mowed 30 82 The accompanying diagram shows Amy’s, Bill’s, and Carla’s marginal cost curves. Marginal cost of lawn mowed $30 Amy’s MC Carla’s MC Bill’s MC 20 10 0 1 2 3 4 5 6 Quantity of lawns mowed b. From the information in the table or from the diagram, you can see that Amy has decreasing marginal cost, Bill has constant marginal cost, and Carla has increasing marginal cost. (Also note that all of them have increasing total cost.) 6. You are the manager of a gym, and you have to decide how many customers to admit each hour. Assume that each customer stays exactly one hour. Customers are costly to admit because they inflict wear and tear on the exercise equipment. Moreover, each additional customer generates more wear and tear than the customer before. As a result, the gym faces increasing marginal cost. The accompanying table shows the marginal costs associated with each number of customers per hour. Quantity of customers per hour Marginal cost of customer 0 $14.00 1 14.50 2 15.00 3 15.50 4 16.00 5 16.50 6 17.00 7 a. Suppose that each customer pays $15.25 for a one-hour workout. Use the profit-maximizing principle of marginal analysis to find the optimal number of customers that you should admit per hour. b. You increase the price of a one-hour workout to $16.25. What is the optimal number of customers per hour that you should admit now? 6. a. The marginal benefit of each customer is $15.25: each additional customer you admit increases the total benefit to the gym by $15.25. So you should admit three customers per hour. Here is how you could think about that decision. Suppose you currently admit no customers. Admitting the first customer gives the gym a marginal benefit of $15.25 and a marginal cost of $14.00. Since the marginal benefit of that first customer exceeds the marginal cost, you want to admit the first customer. For the second customer, the marginal benefit ($15.25) also exceeds the marginal cost ($14.50), so you want to admit the second customer, too. The same is true for the third customer: the marginal benefit ($15.25) exceeds the marginal cost ($15.00), so you also want to admit the third customer. For the fourth customer, however, the marginal cost ($15.50) exceeds the marginal benefit ($15.25), so you do not want to admit a fourth customer. b. By reasoning similar to that in part a, you now want to admit five customers: for the fifth customer, the marginal benefit ($16.25) exceeds the marginal cost ($16.00). For the sixth customer, however, the marginal cost ($16.50) exceeds the marginal benefit, so you do not want to admit a sixth customer. 7. Georgia and Lauren are economics students who go to a karate class together. Both have to choose how many classes to go to per week. Each class costs $20. The accompanying table shows Georgia’s and Lauren’s estimates of the marginal benefit that each of them gets from each class per week. Quantity of classes Lauren’s marginal benefit of each class Georgia’s marginal benefit of each class $23 $28 19 22 14 15 8 7 0 1 2 3 4 a. Use marginal analysis to find Lauren’s optimal number of karate classes per week. Explain your answer. b. Use marginal analysis to find Georgia’s optimal number of karate classes per week. Explain your answer. 7. The marginal cost of one more class is always $20: each additional class that Lauren or Georgia takes will cost an additional $20. a. The optimal number of classes per week for Lauren is one. The marginal benefit to Lauren of the first class is $23, and the marginal cost is $20. Since the marginal benefit exceeds the marginal cost, Lauren wants to take that first class. For the second class, Lauren’s marginal benefit ($19) is less than the marginal cost ($20), so she does not want to take a second class. b. Georgia would be better off adding a second class per week. For the second class, the marginal benefit to Georgia ($22) exceeds the marginal cost ($20), so she wants to take the second class. For the third class, the marginal cost ($20) would exceed the marginal benefit ($15), so Georgia does not want to take the third class. For Georgia, the optimal number of classes per week is two. 8. The Centers for Disease Control and Prevention (CDC) recommended against vaccinating the whole population against the smallpox virus because the vaccination has undesirable, and sometimes fatal, side effects. Suppose the accompanying table gives the data that are available about the effects of a smallpox vaccination program. Percent of population vaccinated Deaths due to smallpox 0% Deaths due to vaccination side effects 200 0 10 180 4 20 160 10 30 140 18 40 120 33 50 100 50 60 80 74 a. Calculate the marginal benefit (in terms of lives saved) and the marginal cost (in terms of lives lost) of each 10% increment of smallpox v­ accination. ­Calculate the net increase in human lives for each 10% increment in p ­ opulation vaccinated. b. Using marginal analysis, determine the optimal percentage of the population that should be vaccinated. 8. a. The accompanying table gives the marginal benefit and the marginal cost of smallpox vaccination. The marginal benefit is the additional number of lives saved if we vaccinate an additional 10% of the population. For instance, if instead of vaccinating 0% of the population (resulting in 200 deaths from smallpox), we vaccinate 10% of the population (resulting in 180 deaths from smallpox), we have saved 20 lives. That is, the marginal benefit of vaccinating 10% (instead of 0%) of the population is 20 lives. Repeating this for the step from 10% to 20% vaccination, and so on, gives us the marginal benefit numbers in the table. The marginal cost is the additional number of lives lost if we vaccinate an additional 10% of the population. For instance, if instead of vaccinating 0% of the population (resulting in 0 deaths due to side effects), we vaccinate 10% of the population (resulting in 4 deaths due to side effects), we have lost 4 lives. That is, the marginal cost of vaccinating 10% (instead of 0%) of the population is 4 lives. Repeating this for the step from 10% to 20% ­vaccination, and so on, gives us the marginal cost numbers in the table. Percent of population vaccinated Marginal benefit in lives saved Marginal cost in lives lost Net increase in human lives per 10% increment in vaccinations 0 20 4 16 20 6 14 20 8 12 20 15 5 20 17 3 20 24 −4 10 20 30 40 50 60 b. The optimal percentage of the population that should be vaccinated is 50%. Suppose we were vaccinating 40% of the population. Then vaccinating an additional 10% (to bring the total up to 50%) would give us a marginal benefit of 20 lives saved. And vaccinating that additional 10% would give us a marginal cost of 17 lives lost. Since the marginal benefit exceeds the marginal cost, we do indeed want to vaccinate that additional 10% of the population. But do we want to go beyond 50% vaccination? Vaccinating an additional 10% (to bring the total up to 60%) would result in a marginal benefit of 20 lives saved and a marginal cost of 24 lives lost due to side effects. Since the marginal cost exceeds the marginal benefit, we do not want to increase the vaccination rate from 50% to 60%. 9. Patty delivers pizza using her own car, and she is paid according to the number of pizzas she delivers. The accompanying table shows Patty’s total benefit and total cost when she works a specific number of hours. Quantity of hours worked Total benefit Total cost 0 $0 $0 1 30 10 2 55 21 3 75 34 4 90 50 5 100 70 a. Use marginal analysis to determine Patty’s optimal number of hours worked. b. Calculate the total profit to Patty from working 0 hours, 1 hour, 2 hours, and so on. Now suppose Patty chooses to work for 1 hour. Compare her total profit from working for 1 hour with her total profit from working the optimal number of hours. How much would she lose by working for only 1 hour? 9. a. We first need to work out Patty’s marginal benefit and marginal cost of each additional hour worked, which are shown in the accompanying table. For instance, as Patty increases the number of hours worked from 2 to 3, her benefit increases from $55 to $75; that is, her marginal benefit is $20. Similarly, as she increases the number of hours worked from 2 to 3, her cost increases from $21 to $34; that is, her marginal cost is $13. Repeating this for increases in the number of hours from 0 to 1, from 1 to 2, and so on, gives the data in the accompanying table. Quantity of hours worked Marginal benefit Marginal cost Profit $30 $10 $20 25 11 14 20 13 7 15 16 −1 10 20 −10 0 1 2 3 4 5 Patty should work for 3 hours because her marginal benefit of going from 2 hours to 3 hours ($20) exceeds the marginal cost of going from 2 hours to 3 hours ($13). But if she went from 3 hours to 4 hours, Patty’s marginal cost ($16) would exceed her marginal benefit ($15). So working that fourth hour is not optimal. b. The accompanying table shows Patty’s total net gain in the fourth column. The total net gain is the difference between total benefit and total cost. Quantity of hours worked Total benefit Total cost Total net gain 0 $0 $0 $0 1 30 10 20 2 55 21 34 3 75 34 41 4 90 50 40 5 100 70 30 atty’s loss from working for only 1 hour instead of the optimal 3 hours is P $41 − $20 = $21. 10. Assume De Beers is the sole producer of diamonds. When it wants to sell more diamonds, it must lower its price in order to induce shoppers to buy more. ­Furthermore, each additional diamond that is produced costs more than the previous one due to the difficulty of mining for diamonds. De Beers’s total benefit schedule is given in the accompanying table, along with its total cost schedule. Quantity of diamonds Total benefit Total cost 0 $0 $0 1 1,000 50 2 1,900 100 3 2,700 200 4 3,400 400 5 4,000 800 6 4,500 1,500 7 4,900 2,500 8 5,200 3,800 a. Draw the marginal cost curve and the marginal benefit curve and, from your diagram, graphically derive the optimal quantity of diamonds to produce. b. Calculate the total profit to De Beers from producing each quantity of ­diamonds. Which quantity gives De Beers the highest total profit? 10. a. The accompanying table shows the marginal benefit and marginal cost of each diamond. The accompanying diagram graphs marginal benefit and marginal cost. From the diagram, you can conclude that the optimal number of diamonds to produce is 5. Quantity of diamonds Total benefit 0 $0 1 1,000 Marginal benefit Total cost Marginal cost $0 $1,000 $50 50 900 2 50 1,900 100 800 3 100 2,700 200 700 4 3,400 5 4,000 200 400 600 400 800 500 6 700 4,500 1,500 400 7 1,000 4,900 2,500 300 8 1,300 5,200 3,800 Marginal benefit, marginal cost of diamond Optimal point $1,400 MC 1,200 1,000 800 600 400 MB 200 0 1 2 3 4 5 6 7 8 Optimal quantity Quantity of diamonds b. The accompanying table calculates the total profit to De Beers from producing each quantity of diamonds. The quantity that gives De Beers the greatest total profit gain is 5 diamonds. This is, of course, just what you found in part a. Quantity of diamonds Total benefit Total cost Total profit 0 $0 $0 $0 1 1,000 50 950 2 1,900 100 1,800 3 2,700 200 2,500 4 3,400 400 3,000 5 4,000 800 3,200 6 4,500 1,500 3,000 7 4,900 2,500 2,400 8 5,200 3,800 1,400 11. In each of the following examples, explain whether the decision is rational or irrational. Describe the type of behavior exhibited. a. Kookie’s best friend likes to give her gift cards that Kookie can use at her favorite stores. Kookie, however, often forgets to use the cards before their expiration date or loses them. Kookie, though, is careful with her own cash. b. The Panera Bread company opened a store in Clayton, Missouri, that allowed customers to pay any amount they like for their orders; instead of prices, the store listed suggested donations based on the cost of the goods. All profits went to a charitable foundation set up by Panera. A year later, the store was pleased with the success of the program. c. Rick has just gotten his teaching degree and has two job offers. One job, replacing a teacher who has gone on leave, will last only two years. It is at a prestigious high school, and he will be paid $35,000 per year. He thinks he will probably be able to find another good job in the area after the two years are up but isn’t sure. The other job, also at a high school, pays $25,000 per year and is virtually guaranteed for five years; after those five years, he will be evaluated for a permanent teaching position at the school. About 75% of the teachers who start at the school are hired for permanent positions. Rick takes the five-year position at $25,000 per year. d. Kimora has planned a trip to Florida during spring break in March. She has several school projects due after her return. Rather than do them in February, she figures she can take her books with her to Florida and complete her projects there. e. Sahir overpaid when buying a used car that has turned out to be a lemon. He could sell it for parts, but instead he lets it sit in his garage and deteriorate. f. Barry considers himself an excellent investor in stocks. He selects new stocks by finding ones with characteristics similar to those of his previous winning stocks. He chalks up losing trades to ups and downs in the macroeconomy. 11. a. Kookie is behaving irrationally, engaging in mental accounting. By losing the dollars incorporated in the gift cards but not losing her cash, she is valuing a dollar in a gift card less than a dollar in her wallet. b. Customers of Panera Bread are behaving rationally, exhibiting concerns about fairness. They are willing to reduce their own economic payoffs in order to be fair to Panera Bread and the beneficiaries of the Panera charitable foundation. c. Rick is behaving rationally, exhibiting risk aversion. Although he could potentially make more money by teaching at the prestigious high school for two years, this is a riskier proposition than taking the job that is guaranteed for five years. d. Kimora is behaving irrationally, exhibiting unrealistic expectations about her future actions. If she can’t finish her projects now, she’s unlikely to complete them while on spring break. e. Sahir is behaving irrationally, engaging in loss aversion. If he were behaving rationally, he would recognize the loss incurred by overpaying for the car and move on by selling it for parts. Instead, because he is unwilling to acknowledge the loss, he is continuing to lose money by letting the car deteriorate in his garage. f. Barry is behaving irrationally, overestimating his stock-picking ability. By not learning from his losing trades as well as his winning trades, he is ignoring evidence that he might not be as good an investor as he believes himself to be. 12. You have been hired as a consultant by a company to develop the company’s retirement plan, taking into account different types of predictably irrational behavior commonly displayed by employees. State at least two types of irrational behavior employees might display with regard to the retirement plan and the steps you would take to forestall such behavior. 12. There are numerous retirement plan policies you could consider to forestall various types of irrational behavior by employees. Here are some examples. Because of status quo bias, many employees do not enroll in company retirement plans. To address this type of predictably irrational behavior, you could suggest that all employees be automatically enrolled in the retirement plan; they should have to actively choose not to enroll. To address unrealistic expectations about their future behavior, you could also suggest that employees who choose not to enroll be given the option to be automatically enrolled after a fixed period of time. To address employees’ overconfidence in their ability to choose investments, the retirement plan could limit movements between different types of funds. Nonprofessional investors are often overconfident and engage in a lot of speculative investing, such as quickly buying and selling stocks. On average, they have significantly worse investment results than professionals, believing that they are better at spotting winners than they really are. WORK IT OUT Interactive step-by-step help with solving this problem can be found online. 13. Hiro owns and operates a small business that p ­ rovides economic consulting services. During the year he spends $57,000 on travel to clients and other expenses. In addition, he owns a computer that he uses for business. If he didn’t use the computer, he could sell it and earn yearly interest of $100 on the money created through this sale. Hiro’s total revenue for the year is $100,000. Instead of working as a consultant for the year, he could teach economics at a small local college and make a s­ alary of $50,000. a. What is Hiro’s accounting profit? b. What is Hiro’s economic profit? c. Should Hiro continue working as a consultant, or should he teach economics instead? 13. a. Hiro’s accounting profit is: $100,000 (total revenue)  − $57,000 (travel and other expenses)   $43,000 (accounting profit) b. Hiro’s economic profit is:   $43,000 (accounting profit) −       $100 (interest forgone) − $50,000 (salary as economics professor) −    $7,100 (economic profit) c. Since Hiro’s economic profit is negative, he would be better off if he didn’t operate the consulting business and taught economics instead. How to Make Decisions Involving Time: Understanding Present Value 1. Suppose that a major city’s main thoroughfare, which is also an interstate ­highway, will be completely closed to traffic for two years, from January 2018 to December 2019, for reconstruction at a cost of $535 million. If the construction company were to keep the highway open for traffic during construction, the highway reconstruction project would take much longer and be more expensive. Suppose that construction would take four years if the highway were kept open, at a total cost of $800 million. The state department of transportation had to make its decision in 2017, one year before the start of construction (so that the first payment was one year away). So the department of transportation had the following choices: (i) Close the highway during construction, at an annual cost of $267.5 million per year for two years. (ii) Keep the highway open during construction, at an annual cost of $200 million per year for four years. a. Suppose the interest rate is 10%. Calculate the present value of the costs incurred under each plan. Which reconstruction plan is less expensive? b. Now suppose the interest rate is 80%. Calculate the present value of the costs incurred under each plan. Which reconstruction plan is now less expensive? 1. a. The present value of plan (i) is: $267.5 million $267.5 million + = $243.18 million + $221.07 million = 1.1 1.12 $464.25 million The present value of plan (ii) is: $200 million $200 million $200 million $200 million + + + = 1.1 1.12 1.13 1.14 $181.82 million + $165.29 million + $150.26 million + $136.60 million = $633.97 million So plan (i) is less expensive. b. The present value of plan (i) is: $267.5 million $267.5 million + = $148.61 million + $82.56 million = 1.8 1.82 $231.17 million The present value of plan (ii) is: $200 million $200 million $200 million $200 million + + + = 1.8 1.82 1.83 1.84 $111.11 million + $61.73 million + $34.29 million + $19.05 million = $226.18 million Plan (ii) is now less expensive. 9 Appendix 2. You have won the state lottery. There are two ways in which you can receive your prize. You can either have $1 million in cash now, or you can have $1.2 million that is paid out as follows: $300,000 now, $300,000 in one year’s time, $300,000 in two years’ time, and $300,000 in three years’ time. The interest rate is 20%. How would you prefer to receive your prize? 2. If you choose to get $1.2 million paid out over the next three years, the present value of those payments is: $300,000 + $300,000 $300,000 $300,000 + + = 1.2 1.22 1.23 $300,000 + $300,000 $300,000 $300,000 + + = 1.2 1.44 1.728 $300,000 + $250,000 + $208,333 + $173,611 = $931,944 Since this is less than $1 million, you would prefer to get $1 million now instead of $1.2 million over four years. 3. The drug company Pfizer is considering whether to invest in the development of a new cancer drug. Development will require an initial investment of $10 m ­ illion now; beginning one year from now, the drug will generate annual profits of $4 million for three years. a. If the interest rate is 12%, should Pfizer invest in the development of the new drug? Why or why not? b. If the interest rate is 8%, should Pfizer invest in the development of the new drug? Why or why not? 3. a. The net present value is: -$10 million + $4 million $4 million $4 million + + = -$392,675 1.12 1.122 1.123 Since the net present value is negative, Pfizer should not invest in the development of this drug: it would be better off putting the $10 million into a bank account that pays 12% interest. b. The net present value is: -$10 million + $4 million $4 million $4 million + + = $308,387 1.08 1.082 1.083 Since the net present value is positive, Pfizer should invest in the development of this drug: the return on its initial investment of $10 million would be better than what it could get if it put the $10 million into a bank account paying 8% interest. Solution Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780