Economics for Managers 2nd Edition 1

Chapter 2 Technical Questions 1. a. Demand increases (assuming that computers are a normal good). S-4 b. There is a d...

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Chapter 2 Technical Questions 1. a. Demand increases (assuming that computers are a normal good).

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b. There is a decrease in the quantity demanded of computers (and no change in the demand curve). c. Demand increases, as the price of a complementary good has fallen. d. There is no change in demand, as semiconductors are an input to computer production and thus a determinant of supply. e. Demand decreases in October, as consumers wait to buy at a lower price in December. 2. a. Supply increases. b. Supply decreases. c. There is a decrease in the quantity supplied of computers (and no change in the supply curve). d. Supply decreases (because costs of production have increased). e. There is no change in supply, as consumer incomes are a determinant of demand. 3. a. X is a normal good. We know this because there is a positive relationship between income and the quantity demanded of good X. b. X and Y are substitutes. We know this because there is a positive relationship between the price of good Y and the demand for good X (thus, as the price of Y rises, consumers buy more X). c. X and Z are complements. We know this because there is a negative relationship between the price of good Z and the demand for good X (thus, as the price of Z rises, consumers buy less X).

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d. QD = 500 – 5PX + 0.5I + 10PY – 2PZ = 500 – 5PX + 0.5(30) + 10(10) – 2(20) = 575 – 5PX e. Price intercept = $115; Quantity intercept = 575; Slope = -0.2. f. The quantity demanded is 500. g. The equation of the demand curve is QD = 625 – 5PX

Price intercept = $125; Quantity intercept = 625; Slope = -0.2.

4. a. X and Z are complements in production. We know this because there is a positive relationship between the price of good Z and the supply of good X (thus, as the price of Z rises, producers produce more X). b. QS = –200 + 20PX – 5PI + 0.5PZ = –200 + 20PX – 5(10) + 0.5(20) = –240 + 20PX c. Price intercept = $12; Slope = 0.05. See text answers for graph. d. Set QS = 0. The minimum price is $12.00. e. QS = –240 + 20(25) = 260. f. QS = –200 + 20PX – 5(5) + 0.5(20) = –215 + 20PX; Price intercept = $10.75; Slope = 0.05.

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5. a. Demand curve: Price intercept = $250; Quantity intercept = 500. Supply curve: Price intercept = $33.3; Slope = 0.33. b. Q* = 260; P* = 120. c. At P = $100, the quantity demanded is 300, while the quantity supplied is 200. Thus, there is a shortage, and the market price will rise. d. At P = $150, the quantity demanded is 200, while the quantity supplied is 350. There is a surplus, and the market price will fall. e. P* = 140; Q* = 320. New demand curve: Price intercept = $300; Quantity intercept = 600. 6. a. Demand increases (the price of a substitute has risen); equilibrium price and quantity rise. See text answers for graphs. b. Supply decreases (the price of an input has risen); equilibrium price rises and quantity falls. c. Demand increases; equilibrium price and quantity rise. d. Supply increases; equilibrium price falls and quantity rises. e. Demand decreases; equilibrium price and quantity fall. 7. a. The increase in the price of gasoline causes the demand for automobiles to decrease (leftward shift of the demand curve), while the decrease in the price of steel causes the supply of automobiles to increase (rightward shift of the supply curve). With no further information, we know that the equilibrium price will fall, but the effect on quantity cannot be determined.

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b. The rise in gasoline prices will cause demand to decrease, which will cause the quantity to fall, all other things held constant. If this effect is larger than the effect of the reduction in steel prices (which will increase supply and cause the quantity to rise), then we may now be able to conclude that the equilibrium quantity of automobiles is likely to fall. 8. a. Because hamburger is an inferior good, demand will increase as incomes decrease, causing the price to rise (rightward shift of demand curve). The improvement in technology that lowers production costs causes supply to increase and tends to lower price (rightward shift of supply curve). With no further information, we know that the equilibrium quantity will rise, but the effect on price cannot be determined. See text answers for graphs. b. The fall in consumer incomes will cause demand to increase (for an inferior good), which will cause the price to rise, all other things held constant. If this effect is smaller than the effect of the improvement in technology (which will increase supply and cause the price to fall), then we may now be able to conclude that the equilibrium price of hamburger is likely to fall. See text answers for graphs. Application Questions 1. Although copper prices reached an all-time high in February 2011, there was concern that the demand from China would not continue, causing a leftward shift in the demand curve and lowering prices. The worldwide economic downturn in 2010 and 2011 also caused demand to decrease, putting downward pressure on copper prices. The supply curve could shift to the left from severe winter weather in Chile, a major copper producer. However, there were also previously unknown stockpiles of copper in China which could be released and cause the supply to increase. Increases in copper prices had caused consumers to decrease the quantity

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demanded (movement along the demand curve) and to substitute cheaper alternative materials, such as aluminum and plastic. The extreme volatility of prices in the copper market was illustrated in the case for the chapter. 2. In February 2013 copper futures prices were at their highest level in nearly four months. This change was another sign that the U.S. economy was growing stronger. Increased manufacturing and construction activity appeared to be increasing the demand for copper and supporting higher prices. Consumers were also demanding more phones, laptops, and air conditioners, all of which use copper as an input. See: Tatyana Shumsky, “Copper Settles 1.4% Higher,” Wall Street Journal (Online), February 1, 2013. 3.a. The drought conditions in the Black Sea wheat belt caused the supply of wheat to decrease and the price of wheat to rise. These conditions were easing,which resulted in an increased supply and lower prices. b. The increased demand from China for soybeans caused the demand curve to shift to the right and prices to increase. c. Farmers responding to high prices and planting more land represents an increase in the number of producers and a rightward shift of the supply curve. d. The USDA prediction also shows the increase in supply as a response to high crop prices. e. Although cocoa production in the Ivory Coast increased in the previous year, possible civil war could cause a decrease in supply and higher prices. f. Weather problems in major wheat-producing countries caused a decrease in the supply of wheat, which increased prices.

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4. a.

The hot summer and the lack of rain caused a significant decrease in the supply of peanuts. This caused a leftward shift in the supply curve that increased the price of peanuts.

b. Because peanuts are an input to the production of peanut butter, the increase in peanut prices shifted the supply curve of peanut butter to the left, thus increasing its price. Peanut butter producers worried about the impact of price increases on their customers, so they tried to find ways to cut other costs, such as shipping and warehousing, to offset the increase in peanut prices. c. The supply of peanuts also decreased due to the high price of cotton. Farmers shifted some of their land from peanut to cotton production. d. The heat also influenced the quality of the peanut plants. Because many plants were scorched, the supply of peanuts used for peanut butter decreased, while the supply for peanut oil increased. 5.a.

Prices in the chicken market had been low relative to the costs of production. The increased costs of production have caused a decrease in supply (leftward shift of the supply curve). This change, combined with increased seasonal demand for chicken (rightward shift of the demand curve) has caused chicken prices to rise.

b. The diversion of corn to make ethanol has increased the price of corn. This increase combined with soybean-meal price increases led to higher production costs for chickens. Higher production costs caused a decrease in the supply of chickens and chicken prices to increase.

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b. See text answers for graphs. c. At Q = 250, MR = 0, and, thus, revenue is maximized. At that point, P = $125, and, thus, TR = $31,250. d. The midpoint of the demand curve is at Q = 250, P= $125. Above that point, demand is elastic, and below that point, demand is inelastic. 5. Demand is elastic (and, thus, revenues will fall if you increase the price and rise if you lower it). Your good is a normal good and is income elastic (or a luxury good). The related good is a complement because a rise in the price of the other good causes a decrease in demand for your product; the goods are fairly strong complements, as the demand for your product is elastic with respect to the price of the other good. 6. Demand is inelastic (and, thus, revenues will rise if you increase the price and fall if you lower it). Your good is a normal good and is income inelastic (or a necessity good). The related good is a substitute because a rise in the price of the other good causes an increase in demand for your product; the goods are fairly good substitutes as the demand for your product is elastic with respect to the price of the other good. Application Questions 1.a. The percent change in price from the discounting policy is -32.6% calculated as follows using the arc elasticity formula: [1.00 – 1.39] / [(1.39 + 1.00) / 2] = -.39 / 1.195 = -0.326 Therefore, the quantity demanded would have to increase by at least 32.6% for the demand to be elastic and total revenue to increase.

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b. The implied cross-price elasticity is positive, assuming that drinks at McDonald’s and its competitors are substitute goods. A decrease in the price of drinks at McDonald’s will decrease the demand for drinks at Burger King and Taco Bell. c. Although the drink discount is designed to increase revenues from the sale of drinks at McDonald’s, the company and its franchisees have to consider other effects of the policy. Revenue from drinks typically compensates for discounts and lost revenue on other products. Discounting drinks might encourage customers to purchase more items from the Dollar Menu and less from the regular menu. Sales of the pricier espresso beverages had been hurt in previous years by the discounted drink policy. However, McDonald’s hopes that the discount policy combined with its new beverages will attract enough customers from its competitors to offset any negative effects on its own menu. 2. We can use the facts in the question to make inferences about the price elasticity of demand for walk-up, unrestricted business airfares. a. On the Cleveland–Los Angeles route, the decrease in fare resulted in about the same revenue as the higher fare. This implies a consumer price elasticity of demand around –1.00. At unit elasticity, any change in price results in no change in total revenue. On the Cleveland– Houston route, the decrease in price resulted in less revenue, but greater market share. Demand was inelastic on this route because quantity demanded increased as the price was lowered, but total revenue decreased. Demand was price elastic on the Houston–Oakland route because the lower airfares resulted in increased total revenue for Continental on this route. b. Consumer behavior differs on the three routes, but is also different from prior expectations.

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As discussed in the chapter, the airlines typically assumed that demand for business travel was inelastic, while demand for leisure travel was elastic. Under this assumption, airline companies did not decrease business fares because they believed they would have lost revenue in doing so. c. Many businesses have gotten tired of paying the high, unrestricted fares for their business travelers. Employees began searching for lower restricted fares that would meet their schedules or using videoconferencing or driving as a substitute for air travel. The terrorist attacks on September 11, 2001, also had a major impact on the airline industry, with many employees refusing to fly in the months following the attacks and with business only slowly recovering in the following years. All of these factors resulted in major changes in business traveler behavior and a probable increase in their price elasticity of demand. The above market tests show that business demand is actually price elastic in certain markets. 3. Public health officials advocate the use of cigarette taxes to reduce teenage smoking because the data in Table 3.7 show that the teenage price elasticity of demand for cigarettes is approximately 1 or higher in absolute value. Thus, demand is unit or even price elastic. Teenagers are sensitive to the price of cigarettes and will reduce or quit smoking in response to the taxes imposed on cigarettes. Cigarette taxes are a good source of revenue for state and local governments, given that the price elasticity of demand for adults is inelastic. This means that an increase in price results in an increase in total revenue, given that the percentage change in quantity is less than the percentage change 4. A price elasticity of demand for urban transit between –0.1 and –0.6 means that demand is inelastic for transit users. Thus, increased fares will result in higher revenue for local gov-

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ernments and transit authorities. This is the economic argument for raising transit fares. However, there may be political constraints on raising fares. The inelastic demand may result from the low income levels and lack of automobiles and other substitute forms of travel of transit riders. Voters may perceive increased fares as placing an unfair burden on these lowincome riders. Transit authorities often obtain voter approval for new transit systems by promising not to raise fares for a certain number of years. Governmental decisions are typically based on many factors other than economic arguments. 5. Information for case studies can be found in sources such as the following: Butscher , Stephan A. Consumer Loyalty Programmes and Clubs, Aldershot, UK and Burlington, VT: Gower, 2002; Basso LJ, Clements MT, Ross TW. Moral Hazard and Consumer Loyalty Programs. American Economic Journal: Microeconomics 2009; 1 (1): 101-123. 6. The price elasticity of demand for the product of an individual firm is typically greater than the price elasticity for the product overall because the individual firm competes with all the other producers of the same product. There are more substitutes for the product of an individual firm than for the product overall. This outcome is most clearly shown in Table 3.7 for agricultural products. The demand for many of the products in the table is inelastic for the product overall, while the table shows a price elasticity of demand for individual producers ranging from –800 to –31,000 (extremely elastic). The price elasticity of demand for individual physicians is also much larger than that for medical or dental care as a commodity. The demand for dental care may be inelastic, while the demand for care from any given dentist is price elastic, given the number of other dentists providing similar care. 7. EBay has been shifting the site’s emphasis away from auctions and toward fixed-price list-

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ings in response to increased competition from Amazon.com and other rivals. The company reduced the charge to post items and increased what it collected when an item sold. The company also installed a new system to determine which items appear first in a search, which uses a formula that takes into account price and how well an item’s seller ranks in consumer satisfaction. EBay also offered fee discounts to their best-rated sellers. See: Geoffrey A. Fowler, “Auctions Fade in eBay’s Bid for Growth,” Wall Street Journal, May 26, 2009. For a review of online auctions, see Young-Hoon Park and Xin Wang, “Online and name-yourown price auctions: a literature review,” in Vithala R. Rao (ed.), Handbook of Pricing Research in Marketing (Cheltenham UK: Edward Elgar, 2009), 419-434; and Kevin Hasker and Robin Sickles, “eBay in the Economics Literature: Analysis of an Auction Marketplace,” Review of Industrial Organization 37 (2010): 3-42. 8. The U.S. Postal Service raised Priority Mail rates by 16 percent, and Bear Creek Corporation reduced its package shipping by 15 to 20 percent. The implied price elasticity of demand (%∆Q/%∆P) ranges from –15/16 = –0.94 to –20/16 = –1.25. If this response is typical for all Postal Service customers, revenues will either remain approximately the same or decrease, given that the price elasticity of demand is approximately unitary or price elastic. Particularly if the demand is elastic, the Postal Service will not be able to reduce its deficit by this strategy because revenues will decrease. Consumers will use Federal Express or UPS instead of the Postal Service to ship their packages.

Chapter 4 Technical Questions 1.a. Auto industry executives have analyzed the shifting population demographics and are now

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beginning to target younger customers rather than the baby boomer generation. They used census and other marketing data to analyze the size of the population trends and the preferences of the younger generations. b. Many companies are using the latest technology, including retina-tracking cameras, to measure consumer behavior for their products. These techniques have again shown that what people want to do and what they say they want to do are often quite different. c. Beer producers are responding to changing consumer tastes by developing new beers and changed packaging. They test a variety of new beers in their research breweries before these products reach the market. 2. The plotted data are simply price and quantity combinations for each of the 10 years. Although the data appear to indicate a downward sloping demand curve for potatoes, many factors other than the price of potatoes changed over this period. These factors included consumer incomes, the prices of other vegetables that could be substituted for potatoes, the introduction of packaged dried potatoes in grocery stores, and the changing tastes for French fries at fast-food outlets. Thus, each data point is probably on a separate demand curve for that year, and the data points in the figure result from shifts in those demand curves. To derive a demand curve from this time-series data, a multiple regression analysis should be run that includes other variables, such as income and the prices of substitute goods. Once these other variables are held constant statistically, the regression results can be used to plot the relevant demand curve showing the relationship between price and quantity demanded, all else held constant. .

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3. In multiple regression analysis, researchers try to include all the relevant variables that influence the demand for a product based on economic theory, market analysis, and common sense. The regression coefficients then show the effect of each variable, while statistically holding constant the effects of all other variables. Because each study is based on a limited set of data, researchers want to be able to generalize the results. Therefore, they test hypotheses about whether each coefficient is significantly different from zero (i.e., whether the variable actually has a positive or negative effect on demand) in a statistical sense. If the variable is not significantly different from zero, its positive or negative coefficient is likely to result only from the given sample of data. The variable does not have an effect on demand in the larger population. Economic theory may give the researcher some knowledge of the expected sign of the variable (i.e., a price variable should have a negative coefficient in a demand equation). In many cases, however, the researcher does not know the expected sign of the variable, so the test is simply to determine whether the variable is significantly different from zero. Application Questions 1. Deloitte Consulting executives have argued that technology innovations have rewired consumers’ brains and behaviors and that managers must be able to adapt to these changes. Retailers should invest in Wi-Fi so that consumers will be encouraged to check product reviews and compare prices. They should be prepared to deal both with customers who want to visit physical locations and those who are content to shop online. See “The Rewired Customer,” CIO-Wall Street Journal, June 4. 2013. 2. Test marketing and price experiments can be established so that consumer characteristics in

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addition to price, such as income and other demographics, can be varied in the different settings. Thus, consumer reaction to price can be measured while holding income constant in one setting and changing it to another level in a different setting. Individuals of various backgrounds can be specifically selected for different focus groups and laboratory experiments. Thus, test marketing, price experiments, focus groups, and laboratory experiments can be constructed to vary one characteristic (usually price), while holding other factors constant. Multiple regression analysis accomplishes this same task statistically. When variables are entered into a multiple regression analysis equation, their effects are statistically held constant. Each estimated coefficient shows the effect on the dependent variable of a one-unit change in an independent variable, holding the values of all other variables in the equation constant. 3. Using expert opinion may bias the results regarding consumer behavior because sales personnel and others closely connected with an industry may have strong incentives to overstate consumer interest in a product. Experts may also have a limited view of the entire set of factors influencing consumer demand. With direct surveys, consumer responses may not accurately reflect their actual behavior in the marketplace. Interviewees may be reluctant to admit that they will not pay a certain price for a product. In any experiment or laboratory situation, there is always the issue of whether consumers will behave the same in the laboratory situation as when facing real-world market decisions. In regression analysis, biases and other statistical problems can arise if relevant variables are omitted from the estimating equations or if irrelevant variables are included. Yet appropriate data may not be available for all relevant variables. There can also be problems interpreting the effects of individual variables if the variables in the equation are highly correlated with each other.

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4. The estimating equation included variables measuring the monetary price of the cars as well as variables measuring the search costs of subsequent visits to a dealer and whether a consumer repurchases the same brand of vehicle (which lowers search costs). Because these variables, as well as the monetary price variable, were statistically significant in the analysis, they indicate that consumers do consider the full price of purchasing an automobile and not just the monetary price.

Chapter 5 Technical Questions 1.a. Capital (K)

Labor (L)

Total Product Average (TP)

Marginal

Product (AP)

Product (MP)

10

0

0

--

--

10

1

5

5

5

10

2

15

7.5

10

10

3

30

10

15

10

4

50

12.5

20

10

5

75

15

25

10

6

85

14.2

10

10

7

90

12.9

5

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10

8

92

11.5

2

10

9

92

10.2

0

10

10

90

9

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b. See shapes of graphs in Figure 5.1 in the text. c. After the fifth worker (or output of 75), there are diminishing marginal returns. d. Average product is maximized at an output level between 75 and 85 (between 5 and 6 workers). 2.a.

Capital (K)

Labor (L)

Total

Average

Marginal

Product (TP)

Product (AP)

Product (MP)

10

0

0





10

1

25

25

25

10

2

100

50

75

10

3

220

73

120

10

4

303

76

83

10

5

357

71

54

10

6

392

65

35

10

7

414

59

22

10

8

424

53

10

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10

9

428

48

4

10

10

429

43

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b. See text answers for graphs. c. After the third worker (or output of 220), there are diminishing marginal returns. d. Average product is maximized at an output level of 303. 3. a. Explicit: lease, inventory, wages, electricity, insurance. Implicit: Jim’s forgone salary and the forgone interest on his savings. b. Fixed: Lease, insurance. Variable: Inventory, wages, electricity (probably varies with output). 4. a. Accounting profit is total revenue less explicit costs = $150,000 – [25,000 + 12,000 + 30,000 + 20,000] = $150,000 – 87,000 = $63,000. b. Economic profit = total revenue – explicit costs – implicit costs = $150,000 – 87,000 – 50,000 – 5,000 = $8,000 5.a K

L

TP

TFC

10 10 10 10 10 10 10 10 10

0 1 2 3 4 5 6 7 8

0 5 15 30 50 75 85 90 92

200 200 200 200 200 200 200 200 200

TV C 0 10 20 30 40 50 60 70 80

b. See Figure 5.2 in the text.

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TC

AFC

AVC

ATC

MC

200 210 220 230 240 250 260 270 280

-40.00 13.33 6.67 4.00 2.67 2.35 2.22 2.17

-2.00 1.33 1.00 0.80 0.67 0.71 0.78 0.87

-42.00 14.66 7.67 4.80 3.34 3.06 3.00 3.04

-2.00 1.00 0.67 0.50 0.40 1.00 2.00 5.00

c. Average total cost is minimized at an output level of approximately 91. Average variable cost is minimized at an output level of approximately 80. 6. a. K

L

MP/TP

TFC

10

0

—/0

500

10

1

25/25

10

2

10

TVC

TC

AFC

AVC

ATC

MC

0

500









500

20

520

20

0.80

20.80

0.80

75/100

500

40

540

5

0.40

5.40

0.27

3

120/220

500

60

560

2.27

0.27

2.54

0.17

10

4

83/303

500

80

580

1.65

0.26

1.91

0.24

10

5

54/357

500

100

600

1.40

0.28

1.68

0.37

10

6

35/392

500

120

620

1.28

0.31

1.59

0.57

10

7

22/414

500

140

640

1.21

0.34

1.55

0.91

10

8

10/424

500

160

660

1.18

0.38

1.56

2.00

10

9

4/428

500

180

680

1.17

0.42

1.59

5.00

10

10

1/429

500

200

700

1.16

0.47

1.63

20.00

b. See text answers for graphs. c. Average total cost is minimized at an output level of approximately 414 (or average total cost of $1.55). Average variable cost is minimized at an output level of approximately 303 (or average variable cost of $0.26).

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7. a See Figure 5.4 in the text. b. The total product curve has a diminishing slope everywhere. Both the marginal product and average product curves are downward sloping with marginal product everywhere below average product after their point of equality. The total variable cost and total cost curves are upward sloping everywhere. The marginal cost and average variable cost curves are upward sloping with marginal cost greater than average variable cost after their point of equality. The marginal cost curve intersects the average total cost curve at its minimum point. 8. An improvement in technology lowers (shifts rightward) marginal cost and all other cost curves (except fixed cost, which is not affected by marginal product). The minimum points on the average total and average variable cost curves will be at higher outputs and lower costs. 9.

L = 50; APL = 50; MPL = 75; PL = $80; TFC = $500. a. AP = Q/L 50 = Q/50 Q = 2,500 AVC = TVC/Q = (80)(50)/2,500 = 4,000/2,500 = $1.60 b. MC = PL/MPL = 80/75 = $1.07 c. ATC = TC/Q = [TVC + TFC]/Q = [4,000 + 500]/2,500 = 4,500/2,500 = $1.80

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d. (1) We don't know if marginal cost is increasing or decreasing, as we have only one data point. (2) Average variable cost must be decreasing, as marginal cost is less than AVC. (3) Average total cost must be decreasing for the same reason. Application Question 1. With a given technology and fixed inputs, as employees at the drive-through windows worked faster to achieve the goal of a 90-second turnaround time for a drive-through customer, the quality of the service began to decline, and worker frustration and dissatisfaction increased. This situation represents diminishing returns as more variable inputs are used relative to the amount of fixed inputs. The management response to these problems was to implement new technologies for the production process: placing an intercom at the end of the drive-through line to correct mistakes in orders and finding better ways for employees to perform multiple tasks in terms of kitchen arrangement. In an attempt to cut costs and increase productivity even further, approximately 50 McDonald’s franchises have been testing remote order-taking. With a remote call center, an order-taker can answer a call from a different McDonald’s where another customer has already pulled up. 2. a. There will be diminishing returns in the drug manufacturing process because much of the testing for quality, gauging of dryness, and testing for bacterial contamination is done by hand. There are bottlenecks in terms of the fixed inputs—batches of chemicals that must be dried, the use of microscopes to count organisms. Adding more workers to the production process without increasing the fixed inputs will result in diminishing returns. b. The FDA allowed firms to maintain these types of production processes to maintain the quality and safety of the drugs. Pursuing this goal made the pharmaceutical companies very S-25

hesitant to change the production process and adopt new technologies because any change would require new FDA approval. The time and paperwork involved would probably put the company at a competitive disadvantage. 3.a. Holding an inventory of shirts creates capital costs in terms of the warehouses needed. If these buildings are owned by Penney’s, there is an implicit cost of using them to hold inventory. Penney’s managers decided it was more efficient to avoid these costs by contracting with TAL Apparel Ltd. to directly supply its stores. b. This innovation also helps demand management because TAL collects point-of-sales data directly from the Penney’s stores and then uses a forecasting model to decide how many shirts to make and in what styles, colors, and sizes. The shirts are then sent directly to the Penney’s stores. This approach helps to match production and demand and minimizes inventory costs. 4. A change in a firm’s total fixed costs of production will shift its average total cost (ATC) curve because ATC = AFC + AVC and AFC = TFC/Q. Thus, an increase in total fixed cost will shift up the average total cost curve. Fixed costs do not influence the marginal costs of production. MC = ∆TC/∆Q = ∆TVC/∆Q. Marginal cost is influenced only by the variable costs, as fixed costs, by definition, do not change.

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5. In a short-run production process, the marginal cost curve eventually slopes upward due to the onset of diminishing returns in the production function. As the marginal product curve begins to decline, the marginal cost curve starts to slope upward. If a firm gets less additional output from each additional worker, the additional cost of producing an additional unit of output increases. Input prices, including the wage rate paid to workers, are held constant when defining a family of short-run cost curves. Any change in input prices causes a shift in the cost curves, not a movement along them.

Chapter 6 Technical Questions 1. A company operates plants in both the United States (where capital is relatively cheap and labor is relatively expensive) and Mexico (where labor is relatively cheap and capital is relatively expensive). a. The cost-minimizing choice depends on the ratio of the marginal productivity of the input relative to the cost of the input in each country. Because input costs are very different in the two countries, it is probable, all other things held constant, that in the United States the firm will choose an input mix consisting of a lot of capital and relatively little labor and that in Mexico it will use relatively more labor and less capital. b. If the factors of production cannot be substituted, the input mix will have to be identical. Additionally, if input productivities vary between countries, the input choice may be similar (for example, if U.S. labor is expensive, but highly productive, the firm will use a lot of labor in the United States as well).

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2. See text answers for graph. 3. Industry studies often suggest that firms may have long-run average total cost curves that show some output range over which there are economies of scale, a wide range of output over which long-run average cost is constant, and, finally, a very high output range over which there are diseconomies of scale. a. See graph for Firm B in Figure 6.3 in the text. The minimum efficient scale occurs where the long-run average cost curve reaches its minimum point b. Because there is a wide range of output over which firms have identical costs, firms need not be the same size to be efficient. Thus, in an industry like this, there could be firms of the same scale or of very different scales of production. 4. a. The minimum efficient scale should be at a high level of output. b. The minimum efficient scale should be at a low level of output. See text answers for graphs. 5. a. The isoquants are shaped like right angles with the point at one worker and one unit of capital. b. The isoquants are downward sloping straight lines. c. The isoquants are the normal shape with a diminishing marginal rate of technical substitution. 6. a. See text answer for graph. b. See text answer for graph.

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7. a. PL = $5, PK = $5. b. While we cannot determine the firm’s precise input choice without knowing the production function, the isocost curve will pivot on the K-axis at K = 100 and get steeper as the wage rate rises. The firm will not be able to produce the current level of output with the same total cost of production. With a higher cost of production (new isocost line), the optimal input mix will use relatively less labor and relatively more capital. 8. a. In the short run, with fixed capital, the firm cannot change its input mix because capital is fixed. Thus, the firm must employ exactly the same inputs if it wishes to produce the same quantity of output. However, the total cost of production will increase (new isocost line). b. The firm’s short-run cost curves will increase (shift leftward). c. In the long run, with all factors variable, the firm will switch to an input mix with less labor and more capital. (Note also that the rise in costs may reduce the quantity that the firm wishes to produce.) The total cost of production will increase in order to produce the original level of output, but not by as much as when the input mix was held constant (part a). See text answers for graphs. Application Questions 1. Apple Inc. had to make decisions about where to locate the assembly plants for its iPhones and iPads as well as deciding how to set up those plants. These decisions involved labor costs but also the logistics of the supply chain. Standard Motor Products also made decisions about whether to produce its fuel injectors in the U.S. or in other countries. The company had to continually re-evaluate these decisions over time.

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2. Sunny Delight Beverage Co. has upgraded five of its U.S. juice factories. Improvements include a “filler room” where machines fill four flavors of juice simultaneously on one highspeed line. In the past flavors were filled on separate lines with each line requiring its own operator. The new combined line requires only two people to operate it. The company also plans to use automated vehicles to replace the current fleet of forklifts and drivers. The German company Stihl has opened a Virginia Beach factory for making chain-saw guide bars that uses 120 robots that run around the clock with only seven workers on each shift. See: Timothy Aeppel, “Man vs. Machine, a Jobless Recovery,” Wall Street Journal (Online) January 17, 2012. 3.

$ SRAC

LRAC

0

1.5

8.0

Output (millions of barrels)

(Source: Kenneth G. Elzinga, Chapter 4, “Beer,” in Walter Adams and James W. Brock (ed.), The Structure of American Industry, 10th ed., Prentice-Hall, 2001.)

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a. Economies of scale are substantial up to a plant capacity of 1.25 to 2.0 million barrels of beer per year. Costs continue to decline more modestly up to a capacity of approximately 8 million barrels per year. The long-run average cost curve is essentially flat beyond 8 million barrels per year, so there are no further economies of scale. b. The firm with the SRAC curve in the diagram represents the type of firm that did not survive over time. It was too small to take advantage of all the economies of scale of production. The long-run average cost curve is the envelope curve of the short-run curves of firms with the most efficient production. Since the SRAC curve in the figure is not tangent to the LRAC curve, this firm did not have the most efficient production techniques even for its size. 4. Economies of scale suggest that large-scale production is cheaper than small-scale production or that the long-run average cost curve slopes downward. However, this large-scale production is cheaper only if a large amount of output is produced and sold. The huge fixed costs of large-scale production lower the average cost of automobiles only if they are spread out over a large number of autos. The plant that lies at the minimum point of a U-shaped long-run average cost curve does not have the lowest costs if only a small number of autos are produced. Automakers would be running plants at unprofitable rates if they did not have a large market share. This explains the behavior in the quote. 5. These results show that competition among a large number of plants and firms in the broiler chicken industry is possible. The minimum efficient scale of production is reached at a very small percent of the entire market. Thus, large-scale production does not act as a barrier to entry in this market. Many plants and firms can compete because they do not need to be of huge scale to obtain low costs of production.

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Chapter 7 Technical Questions 1. a. In all three graphs, the profit-maximizing (or loss-minimizing) output occurs where marginal revenue equals marginal cost. In part (a) the firm is not making a profit, as P < ATC, but P > AVC, so it is covering variable costs and, thus, should continue to produce in the short run. b. The firm is making a profit because P > ATC. c. The firm is not making a profit, as P < ATC, and is not covering variable costs because P < AVC; thus, it should shut down.. 2.a.

Number

Average

Average

Fixed

Variable

Total

Marginal

Variable

Total

of Worker

Output

Cost

Cost

Cost

Cost

Cost

Cost

Hours

(Q)

(TFC)

(TVC)

(TC)

(MC)

(AVC)

(ATC)

0

0

15,000

0

15,000







25

100

15,000

575

15,575

5.75

5.75

155.75

50

150

15,000

900

15,900

6.50

6.00

106.00

75

175

15,000

1,100

16,100

8.00

6.28

92.00

100

195

15,000

1,275

16,275

8.75

6.53

83.46

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125

205

15,000

1,400

16,400

12.50

6.82

80.00

150

210

15,000

1,500

16,500

20.00

7.14

78.57

175

212

15,000

1,585

16,585

42.50

7.47

78.23

b. The firm will produce 205 units. c. The firm’s profit is [(12.50)(205)] – 16,400 = 2,562.50 – 16,400 = –$13.837.50. The firm is losing money, but if it were to shut down, it would lose $15,000 (its fixed costs); thus, the loss-minimizing choice is to stay in business in the short run (as P > AVC). d. See text answer for graph. 3. See Figure 7.2 in the text. The shutdown point is the point at which P = min AVC. The breakeven point is the point at which P = min ATC. The firm’s short-run supply curve is the marginal cost curve above the shutdown point. 4. Supply curve S2 is more elastic than supply curve S1. We can infer this because, for a given change in price, the change in quantity supplied is far greater on supply curve S2 (in other words, a given percentage change in price leads to a larger percentage change in quantity supplied). 5. a. The industry is in long-run equilibrium if quantity supplied equals quantity demanded and there are no firms that wish to enter or exit the industry. In the representative graphs, firms are just breaking even, so there will be no entry or exit. See Figure 7.3 in the text. b. The increase in demand causes the price to rise to P2. Thus, marginal revenue rises for the firms, and they will produce more and make a positive profit (as P > ATC).

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c. Positive short-run profits will induce more firms to enter the industry, given enough time. Thus, industry supply increases, causing equilibrium price to fall and quantity to rise. This continues until the price falls to the original price, at which firms just break even, and there is no further incentive for entry. There will be more firms in the new long-run equilibrium, but each firm will produce the original quantity (Q1) and make zero economic profits. 6. a. The decrease in demand causes the price to fall to P2. Thus, marginal revenue falls for the firms, and they will produce less and make a loss (as P < ATC). See text answer for graphs. b. Losses will induce firms to exit the industry, given enough time. Thus, industry supply will decrease, causing equilibrium price to rise and quantity to fall. This continues until the price rises to the original price, at which firms just break even, and there is no further incentive for exit. There will be fewer firms in the new long-run equilibrium, but each firm will produce the original quantity (q1) and make zero economic profits. 7. a. The short-run ATC curve is tangent to the long-run AC curve at its minimum point (QE), but the short-run curve slopes up more steeply. The short-run marginal cost curve intersects both average cost curves at their minimum point. In the long run, competitive firms must produce the cost-minimizing output, where P = min ATC (QE) on the graph. If it is possible to make a positive profit, more firms will enter; thus, price will fall as industry supply increases. This forces firms to produce at the efficient scale; otherwise, they will make a loss, forcing exit in the long run. b. The profit-maximizing output is found at the point where P (= MR) = MC. If P > PE, the short-run profit-maximizing output must be at a higher quantity than QE. S-34

Application Questions 1. There are a large number of potato farmers, and each produces such a small amount relative to the entire market that individual farmers have no control over the price of potatoes. The price is set by the market forces of demand and supply. The farmers in the case previously complained about the low price of potatoes and their debts, but they were unable to organize any cooperative effort to control supply and improve marketing, given the number of producers and their independent behavior. This changed at the time of the case with the formation of the United Potato Growers of America. The response to high prices in the article is predicted by the model of perfect competition. High prices and profits from the 1995 crop caused farmers to plant far more potatoes in 1996. Given favorable weather and insect conditions, this increase in supply resulted in a drop in price from $8.00 to $2.00 per 100-pound sack. Because this price was only about one-third the cost of production, some farmers would plant fewer or no potatoes in the next cycle, shifting the supply curve to the left and driving price back up. 2.a. The greater number of uses for cranberries increases the demand for the product, resulting in higher prices and greater profitability for cranberry producers. b. The factors creating a smaller crop of cranberries cause the supply curve to shift left, resulting in higher prices. We can infer from the statement that the demand for cranberries is probably inelastic, resulting in higher total revenue with the higher prices. Thus, profits decline by a smaller percent than the decrease in cranberry production.

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c. All of these health-related factors associated with consuming cranberries will increase the demand for the product, resulting in higher prices and profitability. d. Ocean Spray has been using the health benefits of cranberries to develop and promote a wider variety of cranberry drinks. 3.. These facts for the furniture industry are consistent with the model of perfect competition. a. The industry is composed of a large number of small firms. These firms do not have the financial backing to make investments in new technology and equipment, so they have difficulty increasing their productivity and lowering costs. b. These data show that the industry is very unconcentrated. The three largest firms account for only 20 percent of the market share, with the remainder split among 1,000 other manufacturers. c. Capital spending by furniture manufacturers is low compared with other manufacturing firms. This means that furniture manufacturers use outmoded, labor-intensive production techniques that increase their costs. If firms cannot influence price in a competitive market, they must be able to lower their costs to survive. d. Manufacturers have to produce a huge number of furniture options to satisfy consumer demand. This range of options slows production and increases costs, also causing a competitive disadvantage. e. There is ease of entry and exit in the industry because there are no significant economies of scale that could act as a barrier to entry.

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f. As in other competitive industries, the furniture trade association works to increase the demand for the entire industry. g. Furniture manufacturers are attempting to work cooperatively in the political arena to have the U.S. government impose tariffs on Chinese imports, making them more expensive and helping the U.S. industry. h. Changes in technology have made the furniture industry global with competition from around the world. 4. Overall, the statement is false. Information about a perfectly competitive firm’s fixed costs is not needed to determine the profit-maximizing level of output. Profit maximization occurs at that level of output where marginal revenue equals marginal cost. In perfect competition, this is also the point where price equals marginal cost. Because marginal cost shows the change in total cost as output changes, it does not incorporate fixed costs. Fixed costs are relevant to determining the level of profit earned at that level of output. The relationship between price and average total cost determines whether profits are positive, zero, or negative. Because ATC = AFC + AVC, fixed costs are relevant for determining the level of profit. 5. In a perfectly competitive industry, the market price is $25. A firm is currently producing 10,000 units of output, its average total cost is $28, its marginal cost is $20, and its average variable cost is $20. a. It is true that the firm is currently producing at the minimum average variable cost. Marginal cost equals average variable cost of $20. Given U-shaped cost curves, the equality of

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marginal and average variable costs occurs at the minimum point of the average variable cost curve. b. The firm should produce more output to maximize its profit. At the current level of output, the price of $25 is greater than the marginal cost of $20. Because price equals marginal revenue, the firm should increase output until marginal revenue equals marginal cost. c. At the profit-maximizing level of output, average total cost will be less than the current value of $28 because MC < ATC at the current output, so ATC must be decreasing. Profit maximization occurs at the level of output where P = MR = MC = $25.

Chapter 8 Technical Questions 1. See Figure 8.1A in the text. 2. See Figure 8.1B in the text. The ATC curve must be above the demand curve at all points. 3. The demand curve is QD = 500 – P or P = 500 – QD. MR = 500 – 2Q. The monopolist has constant marginal and average total costs of $50 per unit. a. MR = MC 500 – 2Q = 50 450 = 2Q Q = 225, P = $275

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b. Profit = TR – TC = (P)(Q) – (ATC)(Q) = (275)(225) – (50)(225) = $61,875 – 11,250 = $50,625 c. Lerner index = (P – MC)/MC = (275–50)/50 = 4.5 4. See text answer for graph. For simplicity, assume that marginal cost is constant. Persuasive advertising makes demand more inelastic (shifts from demand curve D1 to D2), and as elasticity decreases, the markup over marginal cost (and, thus, market power) is greater. However, advertising also increases fixed costs, and, thus, whether profit rises depends on the effectiveness of advertising relative to its cost. 5. The concentration ratio for Industry A is 70. The concentration ratio for Industry B is 39. Industry A is more concentrated. 6. a. The three-firm concentration ratio for Industry C is 75, whereas it is 95 for Industry D. In both industries, the four-firm concentration ratio is 100 because these firms account for the entire market. b. The HHI index in Industry C is 2,500. The HHI index for Industry D is 6,550. c. Although the four-firm concentration ratios are the same, the three-firm ratios and the HHI show that Industry D would be of more concern to antitrust authorities. The HHI index is far higher due to the presence of one very large firm, which undoubtedly has more market power than any of the four equally sized firms in the other industry. Three firms control 95 percent of the market for Industry D and only 75 percent for Industry C. 7. a. See Figure 8.4A in the text. The firm is currently making a profit.

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b. Because there are no barriers to entry in a monopolistically competitive industry, positive profits will induce entry. As more firms enter the industry, demand for each individual firm will decrease until there are no more profits to be made. At that point, P = ATC for each firm, and the industry is in long-run equilibrium. See Figure 8.4B in the text. 8. Effective advertising may increase demand and make it more inelastic. But it also increases costs. Thus, advertising may lengthen the period during which the firm is able to make a positive profit, but with demand decreasing due to the entry of other firms and costs rising, in the long run, profits must be zero. See text answer for graph. Application Questions 1.

In June 2013, Eastman Kodak Co. announced that it had reached a deal for $895 million in debt financing from three major banks for its planned emergence from bankruptcy protection. The new financing arrangement is more favorable than the existing commitment. The company also announced that it would keep some of its operations in Rochester, NY, and it would provide $49 million for environmental cleanup at its Eastman Business Park. See: Ben Fox Rubin, “Kodak Reaches Financing Deal,” Wall Street Journal (Online), June 20, 2013; Associated Press, “NY: Kodak will keep some operations in Rochester,” Wall Street Journal (Online), June 19, 2013.

2.a.

As with Eastman Kodak Co. in the opening case of the chapter, American Greetings Corp. has faced declining market power from changing consumer preferences for new technology. Many customers who sent physical holiday greeting cards in the past are now using the Internet and mobile phones to express their feelings. This change has caused a long-term decline in the greeting card industry.

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b.

The company has used discount pricing strategies to increase sales of greeting cards. However, the question for managers is how sensitive are customers to price and will a lower price be sufficient to keep customers from switching to electronic media. The company may have to increase its e-card and digital offerings to survive in the future.

3. Drug companies fight to maintain their patents as long as possible to increase the profitability of their drugs. They may engage in “product switching”—retiring an existing drug and replacing it with a modified version that prevents pharmacists from substituting a cheaper generic for the branded drug. There have been numerous lawsuits over patent infringement. 4.a. Demand in China influenced Parker Pen Co.’s strategies through both income and consumer preferences variables. Household income in China had increased, which gave consumers greater ability to pay for both inexpensive and expensive pens. China’s gift-giving culture created a demand for expensive pens as a status symbol. The latter factor, in particular, differed from consumer behavior in North America and Europe where many persons no longer used pens of any form. b. Parker already faces competition in the expensive-pen market, which will increase if profits continue to grow. This could erode the company’s market power and force it to develop new strategies to adapt to the Chinese market. 5. a. True. If a monopolist is producing where demand is inelastic, marginal revenue is negative, and total revenue falls as output increases. This cannot be the profit-maximizing level of output, where marginal revenue equals marginal cost. That level of output must occur on the elastic portion of the demand curve.

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b. True and false. It is true that price is greater than marginal cost at the profit-maximizing level of output for a monopolist. However, marginal revenue is equal to marginal cost at this point. Thus, even though consumers are willing to pay more for additional units of output than they cost to produce, the monopolist has no incentive to produce these extra units, as that would reduce profits. c. False. The firm is already producing the profit-maximizing level of output, as marginal revenue of $40 equals marginal cost of $40. However, the price of the product ($80) is less than the average variable cost of $90 (average total cost of $100 minus average fixed cost of $10). Thus, the firm should shut down because it is not even covering its variable costs of production. d. True and false. In monopolistic competition, a firm does have some market power because it produces a differentiated product. However, because there are a large number of firms producing similar products and there is freedom of entry and exit (no large barriers to entry), any positive economic profits will be competed away in the long run. In the long run, monopolistically competitive firms produce where price equals average total cost, although average total cost is still decreasing.

Chapter 9 Technical Questions 1. a. The kinked demand curve assumes that other firms will follow price decreases, but not price increases. b. See Figure 9.1 in the text.

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c. If marginal costs increase or decrease within the discontinuous range of the marginal revenue curve, the point at which marginal revenue equals marginal cost will remain the same. Thus, price and output do not change, even though costs (and profits) are different. 2. a. The dominant strategy for each firm is to price low (because no matter what the other firm does, you are better off pricing low). b. The Nash equilibrium is at (100, 100). At this point, neither firm has an incentive to change strategy, given what the other firm is doing. c. The firms would be collectively better off pricing high, but that is not an equilibrium. They are collectively worse off pricing low, and that is the only equilibrium of the game. 3. a. There is no dominant strategy in this game because no single strategy is better in all cases. b. There are two Nash equilibriums, both with the payoffs (0,0), when either both players drive on the left or both players drive on the right. c. This is a cooperative game because both players benefit from a cooperative solution; there is no incentive to cheat. 4. a. There is no dominant strategy in this game because no single strategy is better in all cases. b. There is no Nash equilibrium in this game. In every case, one player would want to change strategy, knowing what the other player had chosen. c. All of the payoffs add up to zero (or to a constant sum). Whatever one player gains, the other loses, and, thus, there is no way for everyone to win. 5. a. QD = 1000 – 10P or P = 100 – 1/10QD; MR = 100 – 1/5Q; MC = AC = 10.

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Set MR = MC.

100 – 1/5Q = 10

1/5Q = 90

Q = 450

Put quantity into the demand curve equation to find price. P = $55.

Profit = TR – TC = (55)( 450) – (10)(450) = $24,750 – 4,500 = $20,250

b. The monopolist could set a price of $15 (or just below that). Entrants now have no incentive to come in, as they will earn zero profits. If P = $15 and Q = 850, the monopolist’s profit = TR – TC = (15)(850) – (10)(850) = $12,750 – 8,500 = $4,250.

c. The difference in profit (per period) is $16,000. The advantages of a limit price depend on how long entry could be deterred and whether the monopolist expects to be able to keep the current cost advantage.

6. a. If the entrant has already come in, the monopolist gets 20 if he prices high and 5 if he prices low. It is not rational to price low once the entrant is in, and, thus, it is not a credible threat. b. The Nash equilibrium is (20, 10), where the entrant comes in and the monopolist prices high. c. The monopolist would have to make it more desirable to price low, even if the entrant comes in, perhaps by building a large plant or contracting to supply large amounts of output.

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7. a. See Figure 9.2 in the text. b. See Figure 9.2 in the text. c. The monopolist will have a reduced profit (you can see this by finding the original and the new profit areas on the graph). As in question 5, the loss of potential profit does not necessarily mean that the limit price is a bad strategy. It depends on how long entry can be deterred and whether the monopolist can keep a cost advantage. 8. a. The total marginal cost curve is the horizontal sum of the two marginal costs. b. See text answers for graphs. c. If each firm views the cartel price as fixed, then MR (for the firm) > MC, and each firm wishes to expand output. (Of course, if they do, the price must fall.) Application Questions 1. Check the Wall Street Journal and other business sources for articles on airline cooperative behavior. 2. Home Depot and Lowe’s are the leaders in the home improvement industry, so their behavior is interdependent. Each company has developed similar strategies to compete in the flowering plant business, which is an important source of revenue each year. They both try to obtain exclusive rights to sell the most popular plant varieties to limit the market power of their rival. Each company uses a similar strategy to gather information on consumer preferences for various blooms.

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3.a. The ice cream industry does fit the oligopoly model, with two multinationals, Nestle and Unilever, controlling 34 percent of the market. The behavior of the two companies is interdependent. b. The government influenced this oligopoly behavior by allowing Nestle to purchase Dreyer’s Grand Ice Cream, Inc. This move increased Nestlé’s market power and its market share to match those of Unilever. The FTC allowed Nestle to keep Dreyer’s distribution network, but forced it to sell a number of Dreyer’s secondary brands. The move still appears to benefit Nestle. c. Although these oligopolists are competing on price, that fact is not mentioned in the discussion. Most of the discussion focuses on the rivals’ attempts to capture the away-from-home ice cream market in convenience stores, gas stations, and video shops. The distribution network and access to supermarkets are also key components of the firms’ competitive strategies. Both firms are developing new single-serving products that have higher profit margins. Nestle is also working to turn more of its candies into ice cream flavors. 4. Google and Amazon invaded each other’s markets to increase their market power. Both companies are so large that their behavior is interdependent. Google attempted to challenge Amazon’s fast-shipping programs, while Amazon increased its product searches and online advertising. Both companies were responding to consumer demand for online purchases combined with fast and low-cost shipping. 5. Formal cartel behavior of fixing prices and dividing the market is still illegal in most areas. The article shows that even though Stolt and Odfjell appeared to engage in this behavior, they

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knew it was illegal and were trying to leave no paper trail behind. The companies formalized the process of dividing the market and setting prices and even compared the benefits of cooperation with all-out war. Tensions developed between the companies, and there was a danger that the cartel would break down even before antitrust officials entered the scene. Stolt was indicted on charges of price fixing and other illegal cartel activities in September 2006. 6. Oligopoly theory predicts that cartels are inherently unstable. This result was clearly illustrated in the European laundry detergent price-fixing case. The companies engaged in all types of secret behavior to fix prices. However, monitoring the agreements became extremely difficult over time. As soon as one company decided to cheat, others quickly followed with the same behavior.

Chapter 10 Technical Questions 1. a. MR = P(1 + 1/(–5)) = 4/5P > 0

b. MR = P(1 + 1/(–1)) = 0

c. MR = P(1 + 1/(–0.5)) = – P < 0

2. a. m = –1/[1 + (–15)] = 1/14 or 7% b. m = –1/[1 + (–8)] = 1/7 or 14% c. m = –1/[1 + (–3)] = 1/2 or 50% 3. a.

MC = $10, P = $25, price elasticity = –3.0. Therefore, MR = 25(1 + 1/(–3)) = $16.67 >

$10. The price is not optimal, as marginal revenue exceeds marginal cost.

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b. The price should be lowered until MR = MC. 4. a. Q = 6 – P or P = 6 – Q, MR = 6 – 2Q, MC = AC = 1 MR = MC 6 – 2Q = 1 Q = 2.50 P = $3.50 π = TR – TC = ($3.50)(2.50) – (1)(2.50) = $8.75 – 2.50 = $6.25 b. If P = MC = AC = 1, Q = 5 slices of pizza. The firm earns nothing on these slices because price equals AC. However, the firm can charge a fixed price for this option up to the maximum amount of the consumer surplus at P = 1. This is the area of the triangle under the demand curve and above P = 1. Consumer surplus is (0.5)(5)(6–1) = (0.5)(5)(5) = $12.50. If the firm charges a fixed price greater than $6.25, but less than $12.50, it will increase its profit with this two-part pricing strategy. 5. a. Q = 1,000 – 5P or P = 200 – 0.2Q, MR = 200 – 0.4Q, MC = AC = 20. At a price of $80, the quantity demanded is 600. So consumers buy a total of 600 units. b. First, calculate the monopoly price. 200 – 0.4Q = 20. Q = 450; P = $110; profit = ($110 – 20)(450) = $40,500. With the block pricing scheme, the monopolist makes ($120 – 20)(400) on the first 400 units and ($80 – 20)(200) on the next 200 units, or $40,000 plus $12,000 for a total of $52,000. 6. In the business market, the markup (over marginal cost) will be –1/[1 + (–2)] = 100%. In the

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vacation market, the markup will be –1/[1 + (–5)] = 25%. Thus, the ratio of weekday to weekend prices will be 100/25, or 4. Weekday prices will be four times higher than weekend prices. 7. a. QE = 900 – 2PE or PE = 450 – 0.5QE MRE = 450 – QE; MC = AC = 50 MRE = MC 450 – QE = 50 QE = 400; PE = $250 QW = 700 – PW or PW = 700 – QW MRW = 700 – 2QW 700 – 2QW = 50 QW = 325, PW = $375 b. Demand is more elastic in the East. This can be demonstrated by noting that the monopolist has a lower optimal price in that market or by directly calculating elasticity in each market using the point price elasticity of demand formula: eP = P/(P – a). At P = $400, price elasticity in the East is 400/(400 – 450) = 400/–50 = –8.0. Price elasticity in the West is 400/(400 – 700) = 400/–300 = –1.333. 8.

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Sports Package

Kids Package

Parents

10

50

Sports fans

50

10

Generalists

40

40

With the package option of any one package for $50 or the combined bundled package for $70, parents will buy the Kids package, sports fans will buy the Sports package, and generalists will buy both. (Note that generalists will not be willing to buy either package separately.) The level of profits depends, in general, on the number in each group and the value that each group places on each package, but this type of pricing exploits the value that certain consumers place on particular items and, at the same time, attracts more revenue by inducing others (the generalists) to buy the products, too. Application Questions 1. Examples can be found in current business publications. 2. Timken’s strategy changed as a result of the recession in 2001 and the slow recovery thereafter, as well as of the increase in imports. More customers also began to demand the bundled products, so Timken responded in order to maintain their market position. The chapter discussion showed how bundling can increase a firm’s revenues if it attracts customers who would not have purchased the individual components. Bundling is also successful if it reduces the dispersion in willingness to pay. The case presented additional factors, such as the change in production methods and the education of customers, necessary to make bundling a successful strategy. The case also showed that Timken engaged in political action as part of

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its competitive strategy. 3. Linear Technology Corp. faces inelastic demand for many of its products because they are cheap but specialized. Customers need the products (few substitutes) and are willing to pay substantial markups because the prices are so low (small portion of total expenditures). Linear Technology has operated in a cooperative oligopolistic market where each of the 12 major companies tiptoed around one another’s product lines. However, competition may be increasing in this market in the future. 4. Both of these cases are examples of versioning, developing specific products to meet the needs of different customers. In the Wildeck case, the “lite” version of the product attracted price-conscious customers who might have purchased from its competitor. However, many of these customers ended up purchasing the original product, helping Wildeck maintain its market share. The Union Pacific “blue streak” service focused on those customers who wanted faster service and were willing to pay for it. Union Pacific gained because the new service did not cost it much more than the regular service. 5. This is an example of third-degree price discrimination. The publisher segments the U.S. and Indian markets because there is a different willingness to pay in each market. The publisher increases its revenues by charging a lower price in the Indian market, which has more elastic demand. If the publisher charged the high U.S. price in both markets, it would not be able to sell in India. If the publisher is going to sell the textbook online, it will probably have to set a single price, typically the high U.S. price. This means that it will lose the Indian market. However, if the publisher differentiates the product—by, for example, using rupees in the examples in the Indian version—the two versions of the product can be sold in the two

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markets at different prices because they are no longer the same commodity. 6.a. Tolls are popular from the viewpoint of road officials because demand appears to be price inelastic. There are typically few good substitutes for travel on interstate toll roads. As the toll increases, total revenue to the operating agency increases also. b. The impact of maintaining tolls on the New York State Thruway is that road-maintenance costs are borne by Thruway users rather than all taxpayers. This cross-subsidization policy can be controversial because users of the toll-free highway benefit, while Thruway users pay the cost. c. From the data given, the price elasticity of demand for use of the Pennsylvania Turnpike is %∆Q / %∆P = -1% / 43% = -0.023. This is very inelastic demand.

Chapter 11 Technical Questions 1. GDP is the market value of all goods and services produced in the United States in one year. It includes only final goods and services, so the sales of any firms producing intermediate goods are not included. GDP is usually calculated by adding up spending on consumption, investment, government, and net export purchases. Investment includes any changes in inventories that occurred during the year. Spending on imported goods must be subtracted from spending 2. Of the three choices given, only the purchase of a new house is considered to be investment when calculating GDP. Investment refers to business purchases of tangible capital goods and software; all construction purchases, both residential and nonresidential; and changes in in-

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ventories in the national income accounts. The purchase of an automobile for private, nonbusiness use is treated as consumption spending. The purchase of corporate bonds represents the transfer of ownership of existing assets. 3. Transfer payments are not counted as part of government spending because they represent transfers of income among individuals and not purchases by government of goods or services. Transfer payments do become part of consumers' income and can influence the consumption spending category. 4. U.S. GDP measures the total market value of all final goods and services produced in the economy in one year. Imports are subtracted from exports when calculating GDP because they do not entail production in the United States. 5. Real GDP is the current market value of all newly produced final goods and services in a given year measured in constant dollars or adjusted for changes in the price level. Real GDP is nominal current dollar GDP divided by P, a measure of the general level of prices in the economy. Real GDP measures the amount of goods and services produced in a given year, whether or not the economy is operating at full employment. 6. Calculations are also shown in Table 11.E1 on page 483 in the text. Nominal GDP and real GDP are the same ($50) in the 2010 base year. Case 1 shows an increase in prices with no increase in quantities. Nominal GDP increase to $95, while real GDP is constant at $50. Case 2 shows an increase in quantities with no change in prices. Both real GDP and nominal GDP increase to $95. Case 3 shows an increase in both prices and quantities. Both real GDP and nominal GDP increase, although the increase in nominal GDP is

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much greater. TABLE 11.E1: Nominal Versus Real GDP

Year

Coffee (cups)

Milk (gallons)

2010

Price

Quantity

Price

Quantity

$1.00

10

$2.00

20

Expenditure

$10

$40

GDP

$50 (nominal) $50 (real)

2011 (Case 1)

Expenditure

Price

Quantity

Price

Quantity

$1.50

10

$4.00

20

$15

$80

$95 (nominal) $50 (real)

2011 (Case 2)

Expenditure

Price

Quantity

Price

Quantity

$1.00

15

$2.00

40

$15

$80

$95 (nominal) $95 (real)

2011 (Case 3)

Expenditure

Price

Quantity

Price

Quantity

$1.50

15

$4.00

40

$22.50

$160

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$182.50 (nominal)

$95 (real)

7.

Calculations are shown in the following table:

Table 11.1 Nominal Versus Real GDP (billions $) Variable 2005 2006 Nominal GDP $12,623.0 $13,377.2 Percent Change 5.97 Real GDP $12,623.0 $12,958.5 Percent Change 2.66 GDP Deflator (Price changes) 100 103.23 Percent Change 3.23

2007 $14,028.7 4.87 $13,206.4 1.91 106.23 2.91

Application Questions 1.

In July 2012, many firms reported that second quarter earnings would be lower than expected, given slowing demand from customers around the world, particularly in Europe and China. Proctor & Gamble cut its earnings projections for the second time in three months because it lost market share and was trying to manage rising commodity costs. Although the company admitted to some management failures, its condition was also affected by consumers who were still unwilling to pay the higher prices charged for many of its products. Macy’s Inc. also reported a weaker-than-expected performance due to an economic environment that was characterized as “stagnant at best.” See: Jonathan Cheng, “New Jolt Looms for Investors: Earnings,” Wall Street Journal (Online), July 9, 2012.

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2. The changes are shown in the following table: Variable (bil- 1970 1980 1990 2000 2010 lions $) Real GDP $4,266.3 $5,834.0 $8,027.1 $11,216.4 $13,088.0 Consumption $2,738.9 $3,764.5 $5,313.7 $7,604.6 $9,220.9 (64.2%) (64.5%) (66.2%) (67.8%) (70.5%) Investment $473.4 $715.2 $989.9 $1,963.1 $1,714.9 (11.1%) (12.3%) (12.3%) (17.5%) (13.1%) Government $1,233.7 $1,358.8 $1,864.0 $2,097.8 $2,556.8 (28.9%) (23.3%) (23.2%) (18.7%) (19.5%) Exports $175.3 $351.4 $599.7 $1,187.4 $1,663.2 (4.1%) (6.0%) (7.5%) (10.6%) (12.7%) Imports $236.4 $344.5 $672.6 $1,638.7 $2,085.0 (5.5%) (5.9%) (8.4%) (14.6%) (15.9%) The percentage change in real GDP over each decade is: 1970 - 1980 36.7% 1980 – 1990 37.6% 1990 – 2000 39.7% 2000 - 2010 16.7% Consumption spending has remained roughly constant over the 40-year period, varying from 64% to 70% of GDP. Investment spending increased to 17% of GDP in 1990 but then fell back to 13% in 2010, given the effect of the recession. Government spending was a smaller percent of GDP in 2010 than in 1970, 1980, and 1990. Export and import spending have become larger percentages of GDP over the period. 3. Variable Real GDP Gross Private Domestic Investment Nonresidential Fixed Investment Residential Fixed Investment

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 1.8 2.5 3.5 3.1 2.7 1.9 -0.3 -3.5 3.0 1.7 -1.4 3.9 10.1 5.5 2.7 -3.2 10.2 25.0 17.9 4.8 -7.9 1.4 6.2 6.7 8.0 6.5 -0.8 17.8 4.4 8.8 5.2 8.2 9.8 6.2 -7.3 18.7 23.9 22.2 -4.3 -1.3

This table illustrates the collapse of the housing market and its impact on the recession from 2007 to 2009.

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4. Advance estimates of GDP are fairly reliable. Studies have shown that initial estimates of real GDP successfully indicated the direction of change in GDP approximately 98 percent of the time; the direction of change in major GDP components about 88 percent of the time; whether GDP was accelerating or decelerating 75 percent of the time; and whether GDP growth was above, near, or below trend 80 percent of the time. The mean revision between the advance estimate and the latest estimate was only 0.4 percentage point over the 1983–2006 period. See J. Steven Landefeld, Eugene P. Seskin, and Barbara M. Fraumeni, “Taking the Pulse of the Economy: Measuring GDP,” Journal of Economic Perspectives 22 (Spring, 2008): 193–216; Dennis J. Fixler and Bruce T. Grimm, “The Reliability of the GDP and GDI Estimates,” Survey of Current Business 88 (2008): 16–32; U.S. Department of Commerce, Bureau of Economic Analysis, Concepts and Methods of the U.S. National Income and Product Accounts (Chapters 1 – 9), November 2011. Available at http://www.bea.gov/methodologies/index.htm#na. 5. The following information can be found in the CPI Frequently Asked Questions on the Bureau of Labor Statistics web page. a. The CPI is the most widely used measure of inflation in the United States. The President, Congress, and the Federal Reserve use the CPI in developing fiscal and monetary policies. b. The CPI is developed from expenditure information on what families and individuals actually bought derived from the Consumer Expenditure Survey. More than 7,000 families from around the country provide information on their spending habits in a series of quarterly interviews. Another 7,000 families keep diaries listing everything they buy during a twoweek period.

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c. The major groups within the CPI are food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. These groups include user fees, such as water and sewer charges; auto registration fees; tolls; and sales and excise taxes that directly influence the prices of products. The CPI does not include financial investment items such as stocks, bonds, real estate, and life insurance that relate to saving and not consumption. d. BLS data collectors visit or call thousands of retail stores, service establishments, rental units, and doctors’ offices each month to obtain price information on thousands of items. Prices of about 80,000 items are recorded each month based on scientific sampling. Data on specific items recorded previously are collected. New products and changes in the quality of existing products are noted. The information is then sent to the BLS, where commodity specialists review the data. 6. The following table shows the labor force data: The percent of the population in the labor force has increased from 60 percent in 1969 to more than 66 percent in 1992 and later years. The unemployment rate was very low during the booming periods of the late 1960s and the late 1990s. It increased substantially during the recessions of 1982 and 1991. The “jobless recovery” from the 2001 recession is evidenced by the relatively high unemployment rate in 2003. Although the 2007 figures had not yet shown the impact of the slowing economic activity in 2007 and 2008, the impact of the recession from 2007 to 2009 is shown in the 8.9% unemployment rate in 2011.

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Civilian

Civilian

Noninstitution-

Labor Force

Number

Number

Population

(thousands)

Employed

Unemployed

Unemployment

(thousands)

(% of population)

(thou-

(thousands)

Rate (%)

al

sands) 1969

134,355

80,734

77,902

2,832

3.5

99,526

10,678

9.7

118,492

9,613

7.5

136,891

5,692

4.0

137,736

8,774

6.0

146,047

7,078

4.6

139,869

13,747

8.9

(60.1) 1982

172,271

110,204 (64.0)

1992

192,805

128,105 (66.4)

2000

212,577

142,583 (67.1)

2003

221,168

146,510 (66.2)

2007

231,867

153,124 (66.0)

2011

153,617 239,618

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(64.1)

7.

The following table shows the recessions since 1965 from the NBER website:

Peak December, 1969 (IV) November, 1973 (IV) January, 1980 (I) July, 1981 (III) July, 1990 (III) March, 2001 (I) December, 2007 (IV)

Trough November, 1970 (IV) March, 1975 (I) July, 1980 (III) November, 1982 (IV) March, 1991 (I) November, 2001 (IV) June, 2009 (II)

Number of Months 11 16 6 16 8 8 18

The 1980 recession was the shortest. The 1973-75 recession was brought on by the Arab oil embargo, while the 1980 recession resulted from tight monetary policy designed to wring the 1970s inflation out of the economy. The recession that began in December 2007 and ended in June 2009 was not only the longest in this time period, but the longest since the great depression in the 1930s. 8. The article should focus either on changes in taxes and government spending (fiscal policy) or on changes in the money supply in order to influence interest rates (monetary policy). The minutes and press releases issued following meetings of the Federal Open Market Committee contain a clear statement of the goals of price stability, full employment, and adequate economic growth and the Fed’s assessment of future economic conditions.

Chapter 12 Technical Questions

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1. Induced expenditures result from changes in real income. The consumption function, the basis for the aggregate expenditure model, specifies that the primary determinant of household consumption expenditure is the level of real income. We also assume that some investment and import expenditure is induced by changes in income. Autonomous expenditures result from all factors other than income. Consumption, investment, and import expenditures all have an autonomous component. These components are influenced by factors such as taxes, consumer confidence, the interest rate, and the currency exchange rate. Government expenditure is assumed to be entirely autonomous and a function of government policy. Export expenditure is autonomous because it does not depend on changes in domestic real income. It is influenced by income in the rest of the world and the currency exchange rate. 2. The currency exchange rate (R) is defined as the number of units of foreign currency per dollar. As R increases, U.S. imports become cheaper and exports become more expensive, so that import spending increases and export spending decreases. The opposite happens when R decreases. U.S. imports become more expensive and exports become cheaper, so that import spending decreases and export spending increases. 3. The aggregate expenditure function shifts as follows: a. When the real interest rate increases, the aggregate expenditure function shifts down due to decreases in interest-sensitive consumption and investment spending. b. A decrease in consumer confidence causes consumption expenditure to decrease at every level of income. This shifts the aggregate expenditure function down.

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c. Higher taxes on business profits causes investment expenditure to decrease at every level of income. This shifts the aggregate expenditure function down. d. If the economies of many countries in the rest of the world go into recessions, U.S. export spending decreases and the aggregate expenditure function shifts down. 4. a. False. The multiplier measures the change in real income that results from a change in autonomous expenditure. The effect of an initial change in autonomous expenditure is multiplied because the expenditure becomes an additional round of income, of which households spend a certain amount, depending on the marginal propensity to consume. This expenditure generates subsequent declining rounds of income, of which households spend a fraction. The size of the multiplier depends on the marginal propensities to consume, invest, and import. b. False. An increase in government expenditure (G) represents an injection into the circular flow, or expansionary fiscal policy. This is an increase in autonomous expenditure that causes the aggregate expenditure function to shift up. An increase in taxes (T) represents a leakage out of the circular flow and causes a downward shift of the aggregate expenditure function. c. From the perspective of the national income accounts, real income always equals real expenditure, given the definition of the circular flow. We can measure economic activity either by the expenditure/output approach or by the income/earnings approach. This measurement identity does not mean that the economy is always in equilibrium. Equilibrium is achieved when the desired aggregate expenditure just equals the level of income and output produced and there are no unplanned inventory changes. If the economy is in disequiS-62

librium and there are unplanned inventory changes, the accounting identity between income and expenditure still holds because inventory changes are counted as investment. 5.

C0 = 200, I0 = 200, G0 = 100, X0 = 100, M0 = 100, TP = 0, c1 = 0.8, i1 = 0.1, m1 = 0.15 a.

E = C0 + c1(Y – T) + I0 + i1Y + G0 + X0 – M0 – m1Y T=0 E = C0 + I0 + G0 + X0 – M0 + (c1 + i1 – m1)Y E = 200 + 200 + 100 + 100 – 100 + (0.8 + 0.1 – 0.15)Y E = 500 + 0.75Y Y = 500 + 0.75Y Y – 0.75Y = 500 0.25Y = 500 YE = 2,000

b.

New M0 = 200 E = 200 + 200 + 100 + 100 – 200 + (0.8 + 0.1 – 0.15)Y E = 400 + 0.75Y Y = 400 + 0.75Y 0.25Y = 400

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YE = 1,600 Change in Y = 400, change in M = 100, multiplier = 4 m = 1/[1 – (c1 + i1 – m1)] = 1/[1 – (0.8 + 0.1 – 0.15)] = 1/[1 – 0.75)] = 1/0.25 = 4 c.

E = C0 + c1(Y – T) + I0 + i1Y + G0 + X0 – M0 – m1Y T = 100 E = C0 – c1T + I0 + G0 + X0 – M0 + (c1 + i1 – m1)Y E = 200 – 80 + 200 + 100 + 100 – 100 + (0.8 + 0.1 – 0.15)Y E = 420 + 0.75Y Y = 420 + 0.75Y 0.25Y = 420 YE = 1,680

6.

C = 800 + 0.8(Y – TP), I = 200, G = TP = 200, X = M = 0 a.

Y=C+I+G Y = 800 + 0.8(Y – 200) + 200 + 200 Y = 800 + 0.8Y – 160 + 400 Y = 1040 + 0.8Y

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0.2Y = 1040 Y = 5,200 b.

G = 300 Y = 1,140 + 0.8Y 0.2Y = 1,140 Y = 5,700 Y increased by 500, while G increased by 100, so m = 5. m = 1/(1 – MPC) = 1/(1 – 0.8) = 1/(0.2) = 5

c.

Y = 800 + 0.8(Y – 300) + 200 + 300 Y = 800 + 0.8Y – 240 + 500 Y = 1,060 + 0.8Y 0.2Y = 1,060 Y = 5,300 Y increases by 100, so the equilibrium level of income increases even though ∆G = ∆TP.

Application Questions 1.a. The decline in stock market prices represents a decrease in consumer wealth. This would cause a downward shift in the aggregate expenditure function and a lower equilibrium level of income. These changes contributed to the 2007-2008 recession.

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b. Tax rebates would cause an increase in consumption expenditure. This fiscal policy change would cause the aggregate expenditure function to shift up resulting in a higher equilibrium level of income. c. This change in monetary policy on the part of the Fed was designed to stimulate the economy. Lower interest rates would increase consumption and investment spending, shift up the aggregate expenditure function, and create a higher equilibrium level of income. 2. a. A greater sensitivity of interest-related consumption and investment expenditure to changes in the interest rate would make the IRE function flatter and result in a larger amount of interest-related expenditure for a given change in the interest rate. This would result in a larger change in equilibrium income. b. A larger multiplier in the aggregate expenditure model would result in a higher level of equilibrium income for any given increase in interest-related expenditure. 3. The Consumer Confidence Index can be found at the Conference Board web site. Discussions of new data releases are published in The Wall Street Journal and other business publications. 4.

A recession is the falling phase of a business cycle, in which the direction of a series of economic indicators turns downward (Chapter 11). Real GDP typically falls for at least two quarters. The recession of 2001 caused a lack of consumer demand for many businesses, resulting in declining profits and employee layoffs. The fact that the dollar remained strong did not provide any relief for businesses producing in the United States and competing with foreign companies. The strong dollar decreased the price of U.S. imports and increased the price

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of exports. U.S. manufacturers had to look to other solutions, such as developing new methods to produce and sell their products, in order to counter the negative macroeconomic trends. 5.

The key provisions of the American Recovery and Reinvestment Act of 2009 can be summarized as follows: (1) provide funds to states and localities; (2) support people in need; (3) purchase goods and services; and (4) provide temporary tax relief for individuals and businesses. The Congressional Budget Office has issued a series of reports evaluating the impact of the Act with various economic models. For example, see Congressional Budget Office, Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output from January 2012 Through March 2012, May 2012.

6.

Check articles in the Wall Street Journal and other business publications and the web pages for the Bureau of Economic Analysis (www.bea.gov), the Bureau of Labor Statistics (www.bls.gov), and the Board of Governors of Federal Reserve System (www.federalreserve.gov)

Chapter 13 Technical Questions 1.a. Checking account deposits or demand deposits are part of the M1 money supply. They are generally accepted liquid assets that can easily be used to make transactions and are available on demand.

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b. Stocks are not part of M1 or of any definition of the money supply. They are a type of financial asset that typically provides a greater rate of return, but cannot be used as a medium of exchange. c. Savings account deposits are part of the M2 money supply, but not the M1 definition. They are somewhat less liquid than coin, currency, and demand deposits because they do not have checking privileges. d. Government bonds are not part of the money supply. Like stocks, they tend to provide a greater rate of return, but they cannot be used as a medium of exchange. 2. A fractional reserve banking system is one in which banks are required to keep only a fraction of their deposits as reserves in the bank or on deposit with the Federal Reserve. This system allows them to use the excess reserves to make loans, which provide income to the bank. If these loans are redeposited in the banking system, the overall money supply is expanded. The size of the expansion relates to the size of the reserve requirement. The central bank, or Federal Reserve, influences the amount of reserves in the system, which changes the size of the money supply and prevailing interest rates. 3. If the reserve requirement (rr) is 0.2, the simple deposit multiplier, d, is 1/rr = 1/0.2 = 5. The money multiplier, mm, is (1 + c)/(c + rr + e) = (1 + 0.05)/(0.05 + 0.2 + 0.15) = 1.05 / 0.4 = 2.625. The money multiplier is typically smaller than the simple deposit multiplier because it incorporates the currency deposit ratio, showing the fraction of deposits the public holds as cash, and the excess reserve ratio, showing the excess reserves that banks hold. Both of these factors cause leakages out of the money expansion process. Households that hold currency

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reduce the amount of demand deposits in the system. Banks that hold excess reserves reduce the amount of funds that can be loaned out. 4. The three tools are open market operations, the reserve requirement, and the discount rate. Open market operations, the most important tool, are the buying and selling of government securities, which influences the amount of reserves in the banking system and the federal funds rate that banks charge each other to borrow reserves. With expansionary monetary policy, the Federal Reserve buys securities, which increases the amount of reserves in the system and drives down the federal funds rates. Other short-term interest rates follow the federal funds rate. This stimulates interest-related consumption and investment expenditure and increases real income. Open market operations are the most flexible tool of monetary policy because they can be used on a daily basis. The Fed can also change the reserve requirement, regulating how much of their deposits banks must hold as reserves, and the discount rate, the rate the Fed charges banks to borrow reserves from the Fed. These are less-flexible tools that are not changed as frequently; they are used more for their announcement effects than as major tools of monetary policy. 5.a. The Fed sets the discount rate that it charges banks for borrowing reserves. b. The Fed does not set the federal funds rate, but it does target this rate through open market operations. The FOMC announces its targeted federal funds rate, but the actual rate is determined in the competitive market for bank reserves. The Fed is only one player in this market. c. The prime rate is the rate banks charge their best customers. This rate is set by commercial banks, not the Federal Reserve.

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6. a. True. If real money demand is greater than the real money supply, individuals want to hold more of their assets in the form of money instead of bonds. They sell bonds to obtain money, which drives the price of bonds down and the interest rate up. As the interest rate rises, households want to hold less money, and equilibrium in the money market is obtained at a higher interest rate. When money demand exceeds money supply, equilibrium is reached only at a higher interest rate. b. False. The central bank, or the Federal Reserve, is the institution that controls the money supply and influences interest rates in the United States. The Federal Reserve is not part of the federal government (Congress and the administration). It was designed to be insulated from the political system in this country. The monetary policy of the Federal Reserve is used more than the fiscal policy of the federal government (taxes and expenditure) because it is a more flexible tool that can better deal with changing economic conditions. c. False. A decrease in the reserve requirement increases the money supply because banks have more excess reserves to loan out. These excess reserves create further deposits, a fraction of which can also be loaned out. If the reserve requirement is 0.2, the simple deposit multiplier is 1/0.2 = 5. If the reserve requirement decreases to 0.1, the simple deposit multiplier becomes 1/0.1 = 10. This change results in a greater expansion of the money supply. d. False. This statement is closer to a description of the interest-related expenditure and the aggregate expenditure functions that show the relationship between the interest rate and spending on real goods and services (Chapter 12). The real money demand curve shows the quantity of money balances individuals wish to hold at different interest rates. e. True/false. An increase in the nominal money supply by the Federal Reserve shifts the real

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money supply curve to the right. This change results in an increase in the real money supply. An increase in the price level causes a decrease in the real money supply, which shifts the real money supply curve to the left. Application Questions 1. All press releases from the FOMC meetings discuss the targeted federal funds rate and the balance of risks between the goals of price stability and sustainable economic growth. 2. The statements that the FOMC makes after its meetings are becoming increasingly important indicators of future changes in monetary policy. Investors and forecasters analyze the wording of the statements to detect even subtle changes in policy. The “Parsing the Fed” feature for the August 1, 2012 FOMC press release noted that the statement was largely unchanged from the press release for the June 2012 meeting. The biggest change was that the August statement said that the Fed “will provide additional accommodation as needed” compared to the June statement where the FOMC said that it was “prepared” to take further action. See Phil Izzo, “Parsing the Fed: How the Statement Changed,” Wall Street Journal (Online), August 1, 2012. 3. The Beige Book provides summaries of the economic conditions in all 12 Federal Reserve districts. 4. The minutes provide a detailed account of the factors influencing FOMC decisions. 5.a If the money demand curve in Figures 13.5 and 13.6 in the text is less sensitive to the interest rate, it will be steeper than what in shown there. For any given increase in income represented by a rightward shift of the money demand curve, equilibrium in the money market will oc-

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cur at a higher interest rate. b. If there is a greater responsiveness of money demand to changes in income, there is a larger shift in the money demand curve for any change in income. Equilibrium in the money market will be at a higher interest rate.

Chapter 14 Technical Questions 1.

The aggregate demand curve shows alternative combinations of the absolute price level (P) and real income (Y) or GDP that result in simultaneous equilibrium in both the real goods and the money markets. A decrease in the price level causes an increase in the real money supply and a decrease in the interest rate to restore equilibrium in the money market. The lower interest rate causes a higher equilibrium level of income in the real goods market. Thus a lower price level is consistent with a higher equilibrium level of income which is what the aggregate demand curve shows.

2. a. An increase in personal taxes shifts the aggregate expenditure function down and the aggregate demand curve to the left. b. An increase in expected profits and business confidence shifts the aggregate expenditure function up and the aggregate demand curve to the right. c. A decrease in the level of foreign GDP or real income shifts the aggregate expenditure function down and the aggregate demand curve to the left. d. A decrease in the nominal money supply by the Federal Reserve causes a decrease in the real money supply, which increases interest rates and lowers interest-related consumption S-72

and investment expenditure. This causes a downward shift in the aggregate expenditure function and a leftward shift of the aggregate demand curve. 3. An increase in the real money supply caused by an increase in the nominal money supply by the Federal Reserve results in a lower interest rate at the same price level. The lower interest rate stimulates interest-related expenditure and results in a higher equilibrium level of income at the same price level. This is represented by a shift in the aggregate demand curve. If the real money supply increases due to a decrease in the price level, interest rates decrease and there is a higher equilibrium level of income at the lower price level. This is shown by a movement along the aggregate demand curve. 4. a. False. The short-run aggregate supply curve slopes upward as real income and output approach the economy’s potential output. This upward sloping short-run aggregate supply curve occurs because firms’ input costs rise when they have to bid resources away from competing uses, as most inputs are becoming fully employed. As input costs rise, firms charge higher prices for their products, and the absolute price level begins to increase. Firms will produce more real output only as the price level increases. b. False. The long-run aggregate supply curve can also shift over time if there are increases in the amount of inputs (labor, land, capital, and raw materials) in the economy and increases in technology and efficiency. c. True and false. A decrease in the nominal money supply by the Federal Reserve, all else held constant, does shift the aggregate demand (AD) curve left. This policy change causes the real money supply to decrease, resulting in a higher interest rate, which decreases interest-related expenditure and results in a lower equilibrium level of income at the same price

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level. An increase in the price level, all else held constant, results in an upward movement along a given AD curve. The increase in the price level decreases the real money supply, which results in a higher interest rate and a lower level of real income. This results in a movement along a given AD curve, as the nominal money supply is held constant and there is no change in Federal Reserve policy. d. True. The Keynesian portion of the short-run aggregate supply (SAS) curve is the horizontal portion. The assumption is that real output can change from increases or decreases in spending (aggregate demand) without the price level changing. This would be most relevant in a recessionary situation, where there is significant unemployment and excess capacity. Increases in aggregate demand could result in increases in real output because there would be little tendency for wages and prices to rise in this case. e. False. Stagflation occurs when there is an upward shift in the short-run aggregate supply (SAS) curve resulting from a supply shock, such as an increase in the price of oil. With a given aggregate demand (AD) curve, the resulting equilibrium is at a higher price level and a lower level of real output. The economy can both have inflation and be stagnating at a lower level of real output and employment. 5.a In a closed, mixed economy with stable prices, if consumption and investment spending do not depend on the interest rate, the interest-related expenditure (IRE) function is vertical. There is no change in consumption and investment spending in response to a change in the interest rate. The level of this spending is determined by something other than the interest rate. b. Monetary policy has no effect on real income and output because no type of spending is

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affected by changes in the interest rate. 6. With an upward sloping SAS curve, an increase in AD from expansionary fiscal policy results in both an increase in real income (Y) and an increase in the price level (P). There will be a smaller increase in real income than if the price level did not rise. This outcome occurs because the increase in the price level creates a smaller real money supply, which causes the interest rate to rise. This increase in the interest rate chokes off some interest-related spending, thereby increasing real income by a smaller amount. Application Questions 1a. This was one of the nontraditional methods the Fed used since the financial crisis of 20072008 to shift the aggregate demand curve outward and move the economy closer to the fullemployment level of output. In summer 2012 the Fed was debating whether to purchase more assets to further stimulate the economy. b.The policy debate was whether the above actions by the Fed might eventually cause inflation as the shifting aggregate demand curve would eventually move along the upward sloping portion of the short-run aggregate supply curve resulting in inflation and a higher price level. c.A weaker U.S. dollar would tend to increase U.S. exports and decrease U.S. imports. This change would shift aggregate demand to the right and move the economy closer to the fullemployment level of output. d.This statement relates to the many factors influencing business investment. Although Federal Reserve monetary policy focuses on interest rates, lowering these rates may not be sufficient to increase business investment and hiring, shifting the aggregate demand curve to the right. In 2012 many businesses were waiting for the overall economy to improve before increasing

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hiring. 2. Fiscal policy changes relate to decisions by the president and Congress on federal government spending and taxation. The president releases the proposed federal budget every January. Other fiscal policy changes may be proposed, such as the economic stimulus bill in February, 2009. Monetary policy changes typically relate to ongoing decisions by the Federal Open Market Committee and are discussed regularly in all business publications. 3. Responses will include relevant policy descriptions from current business publications. 4. Economists continue to debate the size and duration of the productivity increases from the investment in information technology (IT) that occurred in the late 1990s. The consensus appears to be that investments in information technology played a lesser role in productivity increases after 2000 than they did in the 1990s. It is always difficult to measure productivity changes due to problems in measuring changes in the quality of many goods and services. It can also be difficult to determine whether productivity changes are transitory or more permanent. See the research of Robert J. Gordon, Stephen Oliner and Daniel Sichel, Erik Brynjolfsson, Dale Jorgenson, and Kevin Stiroh. 5. These forecasts are summarized regularly in the Wall Street Journal.

Chapter 15 Technical Questions 1. Table 15.2: Effect of Dollar Appreciation and Depreciation on U.S. Exports and Imports

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R = Euro/$

Domestic Price

U.S. Exports: Televisions

$1,000

Euro 760

Euro 710

X increases

Euro 25,000

$32,900

$35,200

M decreases

Jan 08: R =0.68

Jan 09: R = 0.76

$1,000

Euro 680

Euro 760

X decreases

Euro 25,000

$36,800

$32,900

M increases

U.S. Imports: European Cars

U.S. Exports: Televisions U.S. Imports: European Cars

2.a.

Jan 09: R = 0.76 June 09: R = 0.71 Effect on Exports (X) and Imports (M)

False. A trade deficit occurs when import spending exceeds export spending. There is a government budget deficit when the government spends more than it receives in tax revenue. The two deficits often move together because government deficit spending stimulates the economy, which increases import spending.

b. False. The equality of planned saving and investment determines equilibrium in a closed (no foreign sector), private (no government sector) economy. This is a balance of leakages and injections in the economy. In an open, mixed economy, equilibrium occurs when I + G + X = S + T + M. In this chapter, we rewrote this condition as follows: (X – M) = (S – I) + (T – G). This condition implies that the trade balance must equal the level of private and public saving in the country. c. False. An increase in interest rates in the rest of the world leads to a weaker dollar. U.S. investors supply dollars to the foreign exchange market to purchase euros and yen in order to make financial investments in those countries with the higher interest rates. The inS-77

creased supply of dollars drives down the value of the dollar in foreign exchange markets. d. True. Under a fixed exchange rate policy with global capital flows, a country loses control of its money supply to maintain that exchange rate. To fight a devaluation of its currency, a country’s central bank has to use its foreign exchange reserves to bolster the value of its currency. This typically results in a decreased domestic money supply and higher interest rates. Countries cannot usually make a credible commitment to this policy regardless of the consequences to the economy. Under a flexible exchange rate system, monetary policy is typically more effective than fiscal policy in increasing real GDP. Expansionary monetary policy increases real income, which increases import spending and lowers the exchange rate. This change has a further expansionary effect on real spending. Expansionary monetary policy also lowers domestic interest rates, which decreases the demand for domestic currency and lowers the exchange rate. While expansionary fiscal policy stimulates the economy and increases imports, which may lower the exchange rate, it also increases domestic interest rates, attracts financial capital, and increases the value of the currency. If this effect dominates (as it did in the late 1990s), the higher exchange rate will slow the growth in the economy. 3. The Federal Reserve will be less likely to raise interest rates in this situation because the appreciating dollar is already helping to slow the economy down. An increase in the exchange rate increases import spending and reduces export spending because imports become relatively cheaper and exports relatively more expensive. Net exports decrease and the economy slows down. This change means that the Fed does not have to raise interest rates as significantly in order to restrain the economy.

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4. If income in the United States grows faster than income in its major trading partners, U.S. imports will increase faster than exports. U.S. households and institutions will supply more dollars to the foreign exchange market to purchase those imports. The increase in the supply of dollars will drive the exchange rate down. If the economies of the trading partners begin to grow faster, that will increase the demand for U.S. exports, which will tend to drive up the demand for dollars and the currency exchange rate. 5. In the simplified model of Table 15.12, balance of payments equilibrium is reached at the exchange rate where export spending equals import spending or where the quantity demanded of dollars equals the quantity supplied in the foreign exchange market. The assumption in that model is that the interest rates in the United States and Japan are equal, so there are no net capital flows. The more general condition for balance of payments equilibrium is (X – M) + (ki – ko) = 0. Import spending can exceed export spending, but this is matched by positive capital inflows (ki > ko) of the same amount. The negative balance on the current account must by matched by a positive balance on the capital account. 6. A change in the currency exchange rate (R) causes a movement along the demand curve for dollars. If R increases, imports become cheaper and exports more expensive. There is a smaller quantity of dollars demanded to purchase those exports, so the dollar demand curve slopes downward. The level of foreign income and the interest rate differential between the United States and the rest of the world cause the demand curve for dollars to shift. An increase in foreign income creates a greater demand for dollars at every exchange rate and shifts the demand curve out. If interest rates in the United States are higher than those in the rest of the world, there are higher capital inflows to the United States, creating an increased

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demand for dollars. The supply of dollars curve slopes upward. As the exchange rate increases, imports become cheaper. As import spending increases, the quantity of dollars supplied to the market increases, so there is a larger quantity supplied at a higher exchange rate. The supply of dollars curve shifts if U.S. income increases. This increases import spending, so more dollars are supplied to the foreign exchange market at every exchange rate. If interest rates are higher in the rest of the world than in the United States, the supply of dollars in the foreign exchange market also increases as U.S. households and institutions purchase those foreign financial investments. This also shifts the supply of dollars curve to the right. Application Questions 1. All balance of payments statistics can be found on the Bureau of Economic Analysis international accounts Web page (www.bea.doc.gov/bea/international). 2. The direct foreign investment statistics on the Bureau of Economic Analysis Web page can be broken down by country and area of the world and by industry sector in the United States. Students should find data on how this investment differs by these categories. 3. In summer 2012 a U.S. Treasury spokesperson said that China should not continue with exchange-rate misalignment. Republican presidential challenger Mitt Romney declared he would name China a currency violator. This was a move that could result in a confrontation with China. See Bob Davis and Lingling Wei, “China Shifts Course, Lets Yuan Drop,” Wall Street Journal (Online), July 25, 2012. 4. The value of the euro and the macro policies of the European Union countries are discussed in the Wall Street Journal and other current business publications.

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5. Firms may react to changes in the macro environment by developing new strategies (cutting costs, using more profitable pricing strategies, etc.), or they may try to modify that environment by lobbying Congress for trade protection and tariffs, U.S. policies to influence the currency exchange rate, and the like.

Chapter 16 Technical Questions 1. The slow economic recovery and uncertain global economy in 2012 influenced McDonald’s operations around the world. The incomes of young people, a prime customer base for McDonald’s, had been limited by the recession. The financial crisis and austerity programs in Europe were of particular concern because Europe accounted for approximately 40% of McDonald’s revenue and operating profit. The slowing Chinese economy also affected McDonald’s expansion plans in that emerging market. 2. The companies have matched price cuts, cooking styles, and menu innovations for many years. They all began competing on coffee strategies in 2008, and they have all had to consider whether to adapt to local tastes when expanding to emerging markets. Under threat of legislation and as a marketing strategy, the rivals have all begun posting calorie counts on their menus. 3. If demand was elastic for McDonald’s Dollar Menu items, the percentage change in quantity would be greater than the percentage change in price. Therefore, lowering the price would increase total revenue. From the initial response, it appeared as though the demand was inelastic. Some franchise owners reported that profits were declining from selling the

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discount items. With inelastic demand, a decrease in price results in a decrease in total revenue because the percentage change in quantity is less than the percentage change in price. 4. McDonald’s mini-restaurants cost 30 percent less to build in 1991, but could handle 96 percent of the volume of a full-sized restaurant. This is an example of a decision based on incremental costs and revenues. The lower costs of these smaller units also opened up market niches in small towns and other areas that could not support traditional restaurants. Application Questions 1. To respond to the uncertain macroeconomic environment, McDonald’s developed new strategies on both the consumer demand and cost side of its operations. The company refocused attention on its Dollar Menu and began offering more price discounts and coupons in Europe. It also introduced a new “dual-point” ordering system to increase efficiency in serving customers their food. 2. All of the fast-food chains increased the number of their outlets in emerging markets and expanded the use of drive-throughs and delivery. McDonald’s had realized that there was a period of adjustment for the drive-through innovation in China. Both Dunkin Donuts and Starbucks planned to open restaurants in India, while Starbucks attempted to expand the coffee market in China. Unlike some of its competitors, Domino’s Pizza planned to continue with its U.S. strategy of traditional pizza delivery in emerging markets. 3. The Chinese government allowed McDonald’s to make a deal with China’s largest gas retailer, state-owned Sinopec Group, to build drive-throughs at gas stations across the country. Entry into China was accomplished through an equity joint venture with the Beijing General Corp. of the Agriculture Industry and Commerce United Co. (Beijing’s Department of Agri-

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culture). This agreement enabled the company to receive agricultural subsidies. 4. McDonald’s has focused on changing tastes and preferences by developing more healthy alternatives on its menus. It developed Happy Meals and in-store playgrounds to appeal to children. The company has tried to improve the quality of its service by hiring mystery shoppers to evaluate service, cleanliness, and food quality. McDonald’s has developed different menus and restaurant designs in various countries around the world. More recently, the company increased the nutritional content of its Happy Meals and began posting calorie counts on its menus. 5. Numerous examples can be found in the Wall Street Journal and other business publications.

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