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Solutions to End of Chapter Problems

Farnham, Economics for Managers, 2/e

Chapter 1

Technical Questions

1. Microeconomics focuses on the behavior of individual consumers, firms, and industries as

they operate in a market economy. It analyzes how these various groups respond to changes

in prices that affect their consumption, production, and selling decisions. It also describes

how firms and consumers interact in various types of markets and can be used as a basis for

determining competitive strategies. Macroeconomics focuses on the overall economic

environment in which businesses operate. It analyzes the spending decisions of different

sectors of the economy—the household, business, government, and foreign sectors.

Macroeconomic policy deals with the issues of inflation, unemployment, and economic

growth. Changes in the macroeconomic environment influence firms through the

microeconomic issues of demand, cost, revenues, and profits.

2. Outputs are the final goods and services that firms and industries sell to consumers.

Consumers create a demand for all of these goods and services. Inputs are the resources or

factors of production that are used to produce the final outputs. Inputs include land, labor,

capital, raw materials, and entrepreneurship. Firms’ use of these inputs is related to the

demand for their products.

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3. The four major types of markets are perfect competition, monopolistic competition,

oligopoly, and monopoly. The key characteristics that distinguish these markets are (1) the

number of firms competing with each other, (2) whether the products sold in the markets are

differentiated or undifferentiated, (3) whether entry into the market by other firms is easy or

difficult, and (4) the amount of information available to market participants.

4. In the model of perfect competition, firms are price-takers because it is assumed there are so

many firms in each industry that no single firm has any influence on the price of the product.

Each firm’s output is small relative to the entire market, so that the market price is

determined by the actions of all suppliers and demanders. In the other market models, firms

have an influence over the price. If they raise the price of the product, consumers will

demand a smaller quantity; if they lower the price, consumers will increase the quantity

demanded.

5. In macroeconomics, the five major categories of spending are consumption (C), investment

(I), government (G), export (X), and import (M). GDP = C + I + G + X – M. The first four

categories are added together, while import spending is subtracted because it represents a

flow of expenditure out of the domestic economy to the rest of the world.

6. Fiscal policies are implemented by the national government and involve changing taxes (T)

and government expenditure (G) to stimulate or slow the economy. These decisions are made

by the political institutions in the country. Monetary policies are implemented by a country’s

central bank—the Federal Reserve in the United States. These policies focus on changing the

money supply in order to influence interest rates, which then affect real consumption,

investment spending, and the resulting level of income and output.

Application Questions

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1. When Wal-Mart expanded into Mexico, it had to confront potential resentment from

Mexicans about the increased competition from a foreign company, and it had to deal with

the powers that controlled local commerce, including the national retailing association,

ANTAD, and local bosses, the caciques. The company also had to adapt to local customs,

which included finding native-speaking employees and broadcasting announcements in

native Indian languages.

2. In April, 2008, the Economist Intelligence Unit predicted that Mexico’s annual GDP growth

would gradually accelerate toward a rate of 3.5 percent. However, Mexico’s growth path

will continue to be dependent on the U.S. economic cycle. U.S. growth affects not only

Mexican gross fixed investment and exports, but also its employment, wages, and private

consumption. Mexican economists state that Mexico is the most exposed country in the

world to a U.S. slowdown. One of the major impacts on the Mexican economy is the

remittance of money from Mexican immigrants working in the United States back to

Mexico. The Central Bank of Mexico reported in May 2008 that remittances from the

United States dropped 2.9 percent for the first quarter of 2008 compared with the same

period in 2007. By fall 2008, the weaker United States economy was lowering Mexico’s

growth rate. The Mexican government cut its estimate for GDP growth from 2.8 percent to

2.4 percent. The Mexican central bank also cooperated with the United States Federal

Reserve to increase liquidity in the financial system. See “Mexico: Country Forecast

Summary,” EIU ViewsWire, April 17, 2008; Jane Bussey, “Mexico Feels Our Economic

Pain,” McClatchy-Tribune Business News, April 7, 2008; Miriam Jordan, “Fewer Latino

Migrants Send Money Home, Poll Says,” Wall Street Journal, May 1, 2008; “A Slowing

Mexican Economy,” EIA ViewsWire, September 23, 2008; and “Crisis Management in

Mexico,” EIA ViewsWire, November 12, 2008.

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3a. This is a description of a perfectly competitive market. It discusses factors influencing the

demand and supply of soybeans, where the focus is on the price and quantity in the entire

market, not the decisions of individual producers. It describes the expectation that current

high prices will give soybean farmers the incentive to increase production in the future.

b. This paragraph is a description of interdependent oligopoly behavior. General Motors’

strategy of rebates and zero percent financing is matched by Ford and Daimler/Chrysler.

Oligopoly firms develop their strategies by anticipating the possible responses of their

rivals.

c. This discussion describes the attempt by the U.S. wireless telecommunications industry

to gain monopoly or market power through mergers of independent firms. The paragraph

notes that the traditional phone industry did have a period of monopoly status when the

industry was highly regulated. The monopoly power of the wireless industry is under

constant attack from new technologies and an increase in new entrants into the market.

Even the merged firms will find their monopoly power under attack.

d. Chinese restaurants represent monopolistic competition. There are 36,000 Chinese

restaurants, most of them small, family operations. No national chain dominates these

restaurants, largely due to the use of the wok for cooking. Specialized stoves and chefs

are required for this type of cooking, which has limited the expansion of these firms into

large-scale production.

4. Numerous examples can be found. In general, the more competitive the market is, the more

firms will have to rely on reducing the costs of production, as they have less control over

price. Firms with market power often use all types of strategies. For example, many

restaurants responded to the economic slowdown in 2007 and 2008 by scaling back

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expansion plans, skimping on items like extra sauce and free sour cream, closing sites, and

laying off workers. After examining rivals’ portions of hash browns and french fries and

analyzing leftovers, Vicorp, which owns 400-plus Village Inn and Bakers Square restaurants,

cut back as much as an ounce from each serving of these foods with a projected annual

savings of more than $500,000. See Jeffrey McCracken and Janet Adamy, “Restaurants Feel

Sting of Surging Costs, Debt,” Wall Street Journal, April 24, 2008.

5. Examples of these types of strategies are discussed in Chapter 14. Firms lookded for ways to

increase productivity and cut costs. Many also developed new pricing strategies to increase

their profits or minimize their losses.

Chapter 2

Technical Questions

1. a. Demand increases (assuming that computers are a normal good).

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 of supplied computers (and no change in the supply

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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).

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

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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.

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.

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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.

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

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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. The supply of copper had decreased (leftward shift of the supply curve) due to strikes which

halted production in 2006. Continuing demand from China was expected to shift the demand

curve to the right, although the world-wide recession in 2008 might impact this demand.

The higher copper prices from these supply and demand shifts gave companies the incentives

to mine lower-grade copper, but also gave copper users incentives to find substitutes for the

metal.

2. The boom in copper and other commodity prices continued through the first half of 2008.

These high prices put immense pressure on geologists and engineers in major mining

companies to find new sources of copper, often in remote areas such as the Peruvian Andes.

By April 2008, Rio Tinto employed 950 explorers worldwide and spent 15 percent more on

exploration than it did five years earlier. Many global mining companies were playing

catch-up after a long period of underinvesting in exploration for new mines. However, it can

take years to get a new mine up and running. The high copper prices also continued to make

manhole covers, pipes, wiring, and even public art projects made of bronze (whose main

ingredient is copper) the targets of theft in many U.S. cities. However, in summer and fall

2008, the prices of copper and other commodities fell in response to the slump in global

demand. See Robert Guy Matthews, “Hunters Comb Globe for a Hot Metal,” Wall Street

Journal, April 4, 2008; Sarah McBride, “Copper Caper: Thieves Nab Art to Sell for Scrap,”

Wall Street Journal, May 1, 2008; Allen Sykora, “Copper is Vulnerable to Falling Further,”

Wall Street Journal, November 24, 2008.

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3.a. (1) An unexpected supply glut is an increase in supply. This is represented by a rightward

shift of the supply curve, which drives down the equilibrium price and increases the

equilibrium quantity. (2) A slowdown in the economy or housing market causes a decrease

in the demand for wood products. The demand curve shifts to the left, resulting in a lower

equilibrium price and quantity. (3) The unusually hot weather causes construction delays,

which also decreases the demand for wood products (leftward shift of the demand curve).

(4) The slackened demand in the Asian markets also causes the demand curve for wood

products to shift to the left, resulting in lower prices.

b. The excerpts discuss a possible slowdown in the entire economy or in the housing

sector, one of the major sectors influencing overall economic activity. The Federal

Reserve (the central bank) influences interest rates through its control of the money

supply. Monetary policy impacts mortgage interest rates, which influence the demand

for housing and wood products. Prices in the wood products industry were expected to

recover as long as the Federal Reserve did not raise interest rates significantly. Foreign

demand from Asian markets is also part of the macroeconomic environment.

c. The wood products industry is composed of “thousands of producers who

frequently manufacture excess quantities.” This statement indicates that the industry is

highly competitive, as there are a large number of producers of wood products who are

unable to coordinate their activities. The excerpts also indicate that prices in the industry

are constantly changing as a result of the forces of demand and supply, another sign of a

competitive industry.

4.a. The new demand for ethanol and biodiesel has raised the prices of corn, palm oil, sugar,

and other crops from which these products are made. However, corn, palm oil, and sugar

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are also inputs to a variety of other foods such as beef, eggs, and soft drinks. These

increased costs have caused a leftward shift of the supply curve for these foods, increasing

their prices also.

b. Increasing the amount of land under cultivation for food is represented by a rightward

shift of the supply curve, which would lower food prices.

c. Technological advances, such as better seed varieties, would lower the costs of food

production, shift the supply curve to the right, and result in lower food prices.

d. Rising incomes, particularly in China, increase the demand for food, resulting in higher

food prices.

e. A bumper crop, or a large increase in the supply of various commodities, may be

necessary to keep food prices lower in India and China.

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.

Chapter 3

Technical Questions

1. a. Price elasticity = –1 (unitary elasticity)

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b. Price elasticity = –5.4 (elastic)

c. Price elasticity = –0.54 (inelastic)

2. a. Price elasticity = –1 (unitary elasticity)

b. Price elasticity = –3.0 (elastic)

c. Price elasticity = –0.33 (inelastic)

3. a. Revenue will rise because demand is inelastic. A 10 percent price increase will cause the

quantity demanded to fall by 5 percent, but that will be more than offset by the 10 percent

increase in price on the units that are still sold.

b. Revenue will rise because demand is elastic. A 5 percent price decrease will cause the

quantity demanded to rise by 12.5 percent, and that will more than offset the lower price on

the original units.

c. Revenues will not change. Because elasticity is –1, a 1 percent increase in price will

result in a 1 percent decrease in quantity demanded, and thus revenue will not change.

d. Revenues will rise. Because demand is perfectly inelastic, there will be no change in the

quantity demanded when price increases, and, thus, revenues will increase.

4. a. PX = 250 – 1/2Q

TR = PQ = (250 – 1/2Q)Q = 250Q –1/2Q2

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.

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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 short-run price elasticity of demand is -0.06 (-0.6% / 10%), while the long-run price

elasticity is -0.4 (-4% / 10%). As expected the short-run price elasticity is smaller than the

long-run price elasticity because consumers have more time to change their behavior over

the long run. The income elasticity of demand is 0.5 (-0.5% / -1%). Gasoline is a normal

good with a positive income elasticity of demand (as income increases, gasoline demand

increases and vice versa).

b. The Congressional Budget Office (CBO) report, Effects of Gasoline Prices on Driving

Behavior and Vehicle Markets, was based on four years of data collected from metropolitan

freeways in California from 2003 to 2006. The study showed that average weekday traffic

volumes on some freeways declined slightly in response to higher gasoline prices. Most of

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that response was on freeways adjacent to commuter rail systems which showed slightly

greater ridership. The CBO also found that a 20 percent increase in gasoline prices resulted

in a 2.6 percentage point increase in the market share of new cars. All major car categories

gained market share. However, the market share of all types of light trucks, from minivans

to SUVs to pickup trucks and passenger or cargo vans, fell by 4 to 6 percent.

c. Given the above income elasticity, the weak economy contributed to decreasing the demand

for gasoline. The housing market slump was also a factor as consumers had less home

equity to finance their expenditures. These changes also caused consumers to buy more fuel-

efficient cars.

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. 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

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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

governments 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 low-

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income 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

listings 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:

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Geoffrey A. Fowler, “Auctions Fade in eBay’s Bid for Growth,” Wall Street Journal, May

26, 2009.

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.Wendy’s was trying to determine consumer preferences for a new product, the vanilla

Frosty, to appeal to younger diners. The company brought more than 100 consumer testers

to its headquarters to sample different flavors of vanilla. Although the company ran the risk

of alienating existing customers with the new Frosty, sales increased 25% after Wendy’s

introduced the vanilla Frosty.

b. Kraft Foods had to develop a new Oreo to sell in China because traditional Oreos were too

sweet and too expensive for the Chinese market. The company tested 20 prototypes on a

sample of Chinese consumers to develop the most appealing cookie. It also began a

marketing campaign to educate Chinese consumers about the American tradition of pairing

milk with cookies to increase the demand for Oreos.

c. Fisher-Price had to adapt its toys to consumer preferences in developing international

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markets. The company had to focus on local customs and traditions so that it did not alienate

consumers in these countries.

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.

3. The sign of the regression coefficient (B) shows the effect of the variable on the demand for

hotel rooms, while a t-statistic greater than 2.0 supports the hypothesis that the variable is

significantly different from zero. The regression results indicate that the most important

hotel room attributes for business travelers were price, room quality, a guaranteed

reservation, the availability of a nonsmoking floor, and the availability of free parking.

Except for price, which was negatively related to quantity demanded, all other significant

variables had a positive effect on demand. The low t-statistics on the variables measuring the

quality of public areas, check-in time, and general staff performance indicate that these

variables did not influence business traveler demand for hotel rooms.

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4. 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. The recession of 2008 and lack of demand for its cars forced General Motors Corp. to

declare bankruptcy in June 2009. GM announced it would close 17 factories and parts

centers and cut 20,000 more jobs by the end of 2011. Over the years GM had developed too

many brands and was locked into high costs from its management, marketing, and labor

practices. Years of heavy sales incentives had also decreased its profit margins. See: Neil

King Jr. and Sharon Terlep, “GM Collapses Into Government’s Arms,” Wall Street Journal,

June 2, 2009; John D. Stoll, Kevin Helliker, and Neal E. Boudette, “A Sage of Decline and

Denial,” Wall Street Journal, June 2, 2009.

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2. Test marketing and price experiments can be established so that consumer characteristics in

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.

5. All the coefficients in the table are significantly different from zero because their t-statistics

are greater than 2.0. Thus, all the variables affect the demand for prescription drugs in this

data sample. The price coefficient has a negative sign, as expected, while the income

coefficient is positive, indicating that these drugs are normal goods. An increase in the

number of doctors in a country has a positive effect on demand, as expected. The time trend

variable has a positive coefficient, indicating that demand changes over time due to variables

not explicitly included in the equation. All of the country variables have negative

coefficients, showing that drug consumption in all of these countries is less than that in the

United States. This study is not too useful for managerial decision making because it was

done at a very aggregate level. The price and quantity variables represent expenditure for an

entire country. The time trend variable could represent a variety of factors, while the

country variables could represent many differences in political and health care institutions.

Managers are much more interested in knowing the factors influencing the demand for

specific drugs or classes of drugs, particularly the influence of price and advertising

expenditure. This more-detailed disaggregated information could be used for strategic

decision making.

Chapter 5

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Technical Questions

1.a.

Capital (K) Labor (L) Total Product Average Marginal

(TP) 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
10 8 92 11.5 2
10 9 92 10.2 0
10 10 90 9 -2
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.

Total Average Marginal


Capital (K) Labor (L) 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

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10 7 414 59 22
10 8 424 53 10
10 9 428 48 4
10 10 429 43 1
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 TV TC AFC AVC ATC MC


C
10 0 0 200 0 200 -- -- -- --
10 1 5 200 10 210 40.00 2.00 42.00 2.00
10 2 15 200 20 220 13.33 1.33 14.66 1.00
10 3 30 200 30 230 6.67 1.00 7.67 0.67
10 4 50 200 40 240 4.00 0.80 4.80 0.50
10 5 75 200 50 250 2.67 0.67 3.34 0.40
10 6 85 200 60 260 2.35 0.71 3.06 1.00
10 7 90 200 70 270 2.22 0.78 3.00 2.00
10 8 92 200 80 280 2.17 0.87 3.04 5.00
b. See Figure 5.2 in the text.

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.

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6. a.

K L MP/TP TFC TVC TC AFC AVC ATC MC


10 0 —/0 500 0 500 — — — —
10 1 25/25 500 20 520 20 0.80 20.80 0.80
10 2 75/100 500 40 540 5 0.40 5.40 0.27
10 3 120/22 500 60 560 2.27 0.27 2.54 0.17

0
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).

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

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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

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

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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 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.

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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.

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

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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).

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

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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.

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

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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. Because Toyota was building a new plant, it could incorporate the latest technology into its

production process and design an efficient small plant. The Toyota plant covered 2.2 million

square feet compared with the 3.75 million-square-foot General Motors plant. Toyota also

arranged for 21 suppliers to set up factories on the same site. GM had existing agreements

with suppliers who were located elsewhere and union contracts that prohibited it from using

lower-paid non-union workers to cut costs. Toyota was able to plan out the optimal sized

plant.

2. H.J. Heinz is developing sweeter tomatoes for its ketchup in response to the soaring price of

high-fructose corn syrup which accounts for about 10% of the cost of producing a bottle of

ketchup. Heinz is paying 25% more for its corn syrup that it did two years ago. Tomatoes,

which account for a third of the cost of making a bottle of ketchup, have also become more

expensive with the cost of growing an acre of tomatoes increasing from $1,800 to $2,300.

Heinz has increased its budget for seed research and doubled the size of its seed research

team to 30 people. Although the company has long focused on increasing tomato yields, it

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began putting an emphasis on developing sweeter tomatoes in the past two years as corn

prices began rising. (Source: Julie Jargon, “Seeking Sweet Savings,” Wall Street Journal,

October 2, 2007.)

When the Ted Stevens Anchorage International Airport was planning a new concourse,

Alaska Airlines insisted that the “one thing we don’t want is a ticket counter.” When

Concourse C opened in 2004, it had only one, small traditional ticket counter for the 1.2

million passengers that checked in that area in that year. The new design with self-service

check-in machines and manned “bag drop” stations doubled Alaska’s capacity, halved its

staffing needs and cut costs while speeding travelers through the building in far less time.

Other airlines and other airports have copied these design changes to try to increase

productivity and reduce costs. (Source: Susan Carey, “Case of the Vanishing Airport Lines,”

Wall Street Journal, August 9, 2007)

3.

$
SRAC

LRAC

0 Output
1.5 8.0 (millions
of barrels)

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(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.)

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.

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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.

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.

Average Average
Number 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.

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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 article 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 article 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.

c. All of these health-related factors associated with consuming cranberries will increase the

demand for the product, resulting in higher prices and profitability.

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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.

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

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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 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.

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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

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

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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.

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,

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in the long run, profits must be zero. See text answer for graph.

Application Questions

1. In May 2009, Dell Inc. reported a 63 percent drop in quarterly profit and a 23 percent

decline in revenue. These results were driven by weak business spending during the

previous three months and restructuring changes. Dell reported a 20 percent decline in

laptop revenue and a 34 percent decrease in desktop personal computers for the quarter.

Hewlett Packard Co. also continued to experience weak results. See: Justin Scheck, “Dell

Warns PC Market Hasn’t Yet Hit Bottom,” Wall Street Journal, May 29, 2009.

2.a. As the article notes, InBev hopes to gain from the economies of scale associated with the

takeover. These are both giant companies that would gain more market power from the

merger. They would be able to balance slow growth in mature markets with rapid growth

in emerging markets. Both companies are interested in China, the world’s largest beer

market. The role of financial markets as a barrier to entry is also discussed. InBev has

been able to raise financial capital due to its size and credit rating even in financial

markets that are still very unsettled.

b. There may be different cultures between the two companies that would cause problems for

a merger. InBev may not be able to wring as much savings out of Anheuser as it expects.

There is already public resistance in the United States to the takeover of Anheuser by a

foreign company. Member of the Busch family, who still run and hold stock in the

company, appear to be opposed to the takeover.

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

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cheaper generic for the branded drug. There have been numerous lawsuits over patent

infringement.

4. Walgreen is pursuing new strategies, given the slowing growth in the traditional prescription

market. It is expanding into the provision of health care with the Take Care clinics in its

stores and plans to expand in worksites. It has also expanded into the specialty pharmacy

sector that focuses on infusion drugs and drugs for infertility, cancer, and AIDS. Walgreen’s

rivals, Wal-Mart and CVS Caremark, have taken a different approach that emphasizes

pharmacy benefit managers (PBMs). It is unclear at this time which approach will be more

profitable in the ever-changing health care environment. Note the similarities and differences

of these strategies with those of the independent pharmacies described under the model of

monopolistic competition in the chapter.

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.

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

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$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.

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.

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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.

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

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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.

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.

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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. In spring 2009 most U.S. airlines had adopted a strategy of squeezing more seats into their

planes. Some airlines removed galleys and installed extra seats, while others installed

slimmer seats to get more rows into the planes without reducing legroom. Certain airlines

decreased the space allotted to each row. For all of the airlines, these changes can mean the

difference between profits and losses for their flights. See: “Seat Squeeze: Low-Cost

Carriers Now Offer the Most Legroom,” Wall Street Journal, June 4, 2009.

2. Xerox and Kodak traditionally did not directly compete with each other with Xerox focusing

on office copying and Kodak on film for consumers. Both companies faced competitive

threats, Xerox from inkjet printers and Kodak from the development of digital cameras,

which forced them into the same market, digital color printing. Both companies are located

in Rochester, NY, which makes keeping secrets from each other difficult. Both companies

also face competition from even bigger rivals, Hewlett-Packard and Canon. Xerox and

Kodak are reacting to each other’s strategies by developing a wide range of digital printers,

but both companies face an uncertain future.

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

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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. Procter & Gamble and Colgate are focusing on developing new products with different

characteristics to sell more toothpaste to existing consumers and to appeal to new groups.

Colgate gained the market advantage with its Total toothpaste, which promised to fight gum

disease and whiten teeth. P&G’s Crest responded with marketing that emphasized beauty and

taste. The company used focus groups in a novel way to compare Whitening Expressions

with regular Crest. P&G also researched the Hispanic and African-American communities to

determine what toothpaste characteristics would most appeal to these groups. Both

companies focused on the variety of characteristics that influence consumer demand that we

discussed in Chapter 3.

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 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

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the scene. Stolt was indicted on charges of price fixing and other illegal cartel activities in

September 2006.

6. The proposed cartel is likely to fail because the natural gas producers have not been able to

coordinate their behavior in the past. There are many sources of natural gas around the

world, so alternative supplies would be available even if Russia and Iran formed a cartel.

Because the United States obtains most of its gas from North America, it would be less

vulnerable to this cartel’s actions. The motivation for this cartel is similar to that of the

potato farmers’ cooperative in Chapter 7. Producers in both areas operate in an extremely

competitive market with little control over price. Cooperative behavior is one way to try to

overcome the volatility and uncertainty of a competitive market.

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.

b. The price should be lowered until MR = MC.

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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

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.

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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.

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

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$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 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.

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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

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.

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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 good 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

inventories 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

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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 the table on page 481 in the text.

Nominal GDP and real GDP are the same ($50) in the 2007 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 much greater.

TABLE 11.E1: Nominal Versus Real GDP

Year Coffee (cups) Milk (gallons) GDP


2007 Price Quantity Price Quantity
$1.00 10 $2.00 20
Expenditure $10 $40 $50 (nominal)
$50 (real)
2008 (Case 1) Price Quantity Price Quantity
$1.50 10 $4.00 20
Expenditure $15 $80 $95 (nominal)
$50 (real)
2008 (Case 2) Price Quantity Price Quantity
$1.00 15 $2.00 40
Expenditure $15 $80 $95 (nominal)

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$95 (real)
2008 (Case 3) Price Quantity Price Quantity
$1.50 15 $4.00 40
Expenditure $22.50 $160 $182.50 (nominal)
$95 (real)
7. Calculations are shown in the following table:

Table 11.1
Nominal Versus Real GDP (billions $)
Variable 2000 2001 2002
Nominal GDP $9,817.0 $10,128.0 $10,469.6
Percent Change 3.17 3.37
Real GDP $9,817.0 $9,890.7 $10,048.8
Percent Change 0.76 1.60
GDP Deflator (Price changes) 100 102.40 104.19
Percent Change 2.40 1.75

Application Questions

1. By March 2009 the manufacturing sector has suffered a sharp contraction and had cut many

jobs. However, fewer positions had been eliminated than would be expected. Many

companies had become so lean over the previous decade that assembly lines were running

with only a small number of highly-trained workers. These companies responded to the

recession by cutting hours and firing temporary workers. Manufacturers were also eager to

hold onto workers who were trained to operate their increasingly sophisticated equipment.

See: Timothy Aeppel and Justin Lahart, “Lean Factories Find It Hard to Cut Jobs Even in a

Slump,” Wall Street Journal, March 9, 2009.

2.The changes are shown in the following table:

Variable

(billions $) 1960 1970 1980 1990 2000


Real GDP $2,501.8 $3,771.9 $5,161.7 $7,112.5 $9,817.0

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Consumption $1,597.4 $2,451.9 $3,374.1 $4770.3 $6,739.4
(63.9%) (65.0%) (65.5%) (67.1%) (68.7%)
Investment $266.6 $427.1 $645.3 $895.1 $1,735.5
(10.7%) (11.3%) (12.5%) (12.6%) (17.7%)
Government $715.4 $1,012.9 $1,115.4 $1,530.0 $1,721.6
(28.6%) (26.9%) (21.7%) (21.5%) (17.5%)
Exports $90.6 $161.4 $323.5 $552.5 $1,096.3
(3.6) (4.3%) (6.3%) (7.8%) (11.2%)
Imports $103.3 $213.4 $310.9 $607.1 $1,475.8
(4.1%) (5.7%) (6.0%) (8.5%) (15.0%)
The percentage change in real GDP over each decade is

1960–1970 50.8%
1970–1980 36.8%
1980–1990 37.8%
1990–2000 38.0%
Consumption spending remained roughly constant at approximately two-thirds of GDP.

Investment spending was more volatile. Although government spending decreased as a

percent of GDP over the decade, remember that this spending does not include transfer

payments. Export spending and import spending have become larger percentages of GDP

over the period, signifying the increasing importance of the international economy to the

United States. There was a trade surplus (export spending greater than import spending) only

in 1980.

3.

Percent Change in Variable


Variable 2000 2001 2002 2003 2004 2005 2006 2007 2008
Real GDP 3.7 0.8 1.6 2.5 3.6 2.9 2.8 2.0 1.1
Gross Private 5.7 -7.9 -2.6 3.6 9.7 5.8 2.1 -5.4 -6.7
Domestic
Investment

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Nonresidential 8.7 -4.2 -9.2 1.0 5.8 7.2 7.5 4.9 1.6
Fixed
Investment
Residential 0.8 0.4 4.8 8.4 10.0 6.3 -7.1 -17.9 -20.8
Fixed
Investment

The table shows that nonresidential fixed investment had negative rates of change in the

2001 recession, while residential fixed investment maintained small positive growth rates.

The opposite occurred in the recession of 2007-2008 illustrating the collapse of the housing

market.

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.

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.

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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 two-

week period.

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. The 2007 figures had not yet

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shown the impact of the slowing economic activity in 2007 and 2008.

Civilian Civilian
Noninstitutiona Labor Force Number Number

l
Population (thousands) Employed Unemploye Unemployment

d
(thousands) (% of population) (thousands (thousands) Rate (%)

)
1969 134,355 80,734 77,902 2,832 3.5
(60.1)
1982 172,271 110,204 99,526 10,678 9.7
(64.0)
1992 192,805 128,105 118,492 9,613 7.5
(66.4)
2000 212,577 142,583 136,891 5,692 4.0
(67.1)
2003 221,168 146,510 137,736 8,774 6.0
(66.2)

2007 231,867 153,124 146,047 7,078 4.6

(66.0)

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

Peak Trough Number of Months


December, 1969 (IV) November, 1970 (IV) 11
November, 1973 (IV) March, 1975 (I) 16
January, 1980 (I) July, 1980 (III) 6
July, 1981 (III) November, 1982 (IV) 16
July, 1990 (III) March, 1991 (I) 8
March, 2001 (I) November, 2001 (IV) 8

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December, 2007 (IV)

The 1973-75 recession was the longest, while 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 length of the recession that began in December 2007 is not yet known.

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

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

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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.

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

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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 disequilibrium 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

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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

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

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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

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

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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.

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.

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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. As discussed in Chapter 11, a recession is the falling phase of a business cycle, in which the

direction of a series of economic indicators turns downward. 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 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. In February 2008 Congress passed a $168 billion economic stimulus bill designed to slow

the decline in economic activity. Taxpayers received up to $600 for individuals or $1,200

for married couples, amounts that phased out at higher income levels. In February 2009

Congress passed a $789 billion stimulus bill that included $507 billion in spending programs

and $282 billion in tax cuts. The bill contained more than $150 billion in public works

projects for transportation, energy, and technology and $87 billion to help states meet rising

Medicaid costs. See: “Economic Stimulus,” The New York Times, June 6, 2009.

6. The news article describes the loss of jobs associated with the slowing economy early in

2008. Check the Web page of the Bureau of Labor Statistics (www.bls.gov) to find data and

analysis of the current employment and unemployment situation.

Chapter 13

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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.

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.

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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

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

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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.

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.

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d. False. This statement is closer to a description of the interest-related expenditure and the

aggregate expenditure functions in Chapter 12 that show the relationship between the

interest rate and spending on real goods and services. 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

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 April 30, 2008 FOMC press release noted that the change in the targeted

federal funds rate from 2.25 to 2.00 percent was the seventh cut since September 2007, but it

was “modest by recent standards.” The statement said that the economy “remains weak”

versus “has weakened further” in the March 2008 statement. The Fed now identified a

business-spending slowdown in addition to weakening consumer spending and employment

noted previously. The “substantial easing of monetary policy to date…” language was new.

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Gone was the language regarding “downside risks to growth remain.” This language signaled

that the Fed might be ready to suspend its rate-cutting strategy. See “Spring Pause? Parsing

the Fed,” Wall Street Journal, April 30, 2008.

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 occur 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.

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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

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.

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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 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.

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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

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

1.a Stagflation is represented by an upward shift of the short-run aggregate supply curve due to

major increases in the costs of production unrelated to demand. This results in an

“unwelcome combination of looming recession [stagnation] and persistent inflation.”

b. The slump in housing prices decreased consumer wealth, while tighter lending standards

limited consumer’s opportunities to borrow. Both of these factors caused a decrease in

consumption expenditure and a leftward shift of the aggregate demand curve. Higher oil

prices resulted in an upward shift of the short-run aggregate supply curve which also reduced

real income.

c. Changes in the size of the labor force and productivity relate to shifts of the long-run

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aggregate supply curve. Larger shifts in this curve mean that the economy can grow faster

without generating inflation. See Figure 14.7 in the text.

d. If companies can pass higher food and energy costs onto consumers, this is represented by an

upward sloping short-run aggregate supply curve. This could result in a higher price level

and higher inflation.

e. A declining dollar makes U.S. exports less expensive and stimulates the U.S. economy.

However, it also causes imports to become more expensive and could add to U.S. inflation.

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, 2008. 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

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Technical Questions

1.

Table 15.2: Effect of Dollar Appreciation and Depreciation on U.S. Exports and Imports
R = Euro/$ Domestic Price Jan 05: R = 0.76 Jan 06: R = 0.82 Effect on Exports
(X) and Imports
(M)

U.S. Exports: Televisions $1,000 Euro 760 Euro 820 X decreases

U.S. Imports: European Euro 25,000 $32,900 $30,500 M increases


Cars

Jan 07: R =0.77 Jan 08: R = 0.68


U.S. Exports: Televisions $1,000 Euro 770 Euro 680 X increases

U.S. Imports: European Euro 25,000 $32,500 $36,800 M decreases


Cars

2.a. False. A trade deficit occurs when import spending exceeds export spending. There is a

government budget deficit when the goverment 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.

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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

increased 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.

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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.

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

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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

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 June 2009 U.S. Treasury Secretary Timothy Geithner urged China to move toward a more

flexible exchange-rate regime. Mr. Geithner caused controversy in January 2009 by

asserting that China was manipulating its currency. He later moved away from that

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language. Economists argued that allowing the yuan to rise would be an important sign that

China was serious about increasing its domestic demand. See: Andrew Batson and Maya

Jackson Randall, “Geithner Urges Role for China in Recovery,” Wall Street Journal, June 2,

2009.

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.

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. Higher incomes, increased numbers of automobiles, and the improved road network in China

all stimulated the demand for fast food and influenced McDonald’s strategy of developing

drive-through windows in its restaurants. The company was also influenced by changing

tastes and an evolving social structure in China.

2.The oligopoly model best describes the relationship between McDonald’s and KFC in China.

The two companies have interdependent strategies in terms of restaurant openings, items

included on the menu, and development of drive-throughs. McDonald’s is trying to develop

innovative strategies, given that KFC has the larger presence in China. Both companies have

to decide how much to adapt their menus to local tastes.

3. Mexico had a large current account deficit that had to be financed by capital inflows from

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abroad. The government tried to maintain an exchange rate that was too high. When the

capital flows decreased due to higher interest rates in other countries, there was downward

pressure on the exchange rate. Mexico did not have the reserves to support the exchange rate

and the peso was devalued. Investors also lost confidence in the currency which made the

situation worse.

4. Wal-Mart faced challenges in using the same strategies in Mexico as it did in the United

States. When the company opened a supercenter in Monterrey in 1993, it was criticized for

charging 15–20 percent more than the Wal-Mart in Laredo, Texas, two hours by car to the

north. The company also lacked leverage with Mexican vendors that gave it an advantage in

the United States. Distribution systems were different in Mexico, where thousands of

suppliers shipped directly to stores rather than to retailer warehouses. Wal-Mart also faced

ambivalent preferences for U.S. goods. The Mexican news media warned about shoddy

foreign goods, and some consumers were moved by the spirit of Mexican nationalism to

purchase domestically produced goods. Differences in Mexican lifestyles also meant that the

model of a large store with thousands of products did not immediately transfer to Mexico.

5. 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

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.

6. McDonald’s mini-restaurants cost 30 percent less to build in 1991, but could handle 96

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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. China’s investment in its highways had been a key to boosting its overall economic growth.

However, this also led to an increase in the number of automobiles and influenced

McDonald’s strategy of focusing on developing drive-through windows. China’s economic

stimulus plan in fall 2008 benefited many U.S. companies from tire and excavator makers to

the fast-food chains. See: James T. Areddy and Timothy Aeppel, “China’s Stimulus Spurs

U.S. Business,” Wall Street Journal, April 30, 2009. The 2008 recession increased the

demand for Wal-Mart’s products as more affluent customers began shopping there. The

company also attempted to gain some of the business available from the demise of Circuit

City Stores Inc. during the recession. In May 2009 Wal-Mart announced its expansion into

India, a market dominated by small retailers. See: Miguel Bustillo, “Wal-Mart Steps Up Its

Game in Electronics Aisle,” Wall Street Journal, May 18, 2009; Eric Bellman, “Wal-Mart

Exports Big-Box Concept to India,” Wall Street Journal, May 28, 2009.

2. McDonald’s responded to the changing economic conditions in China that included

increased incomes, urbanization, and use of automobiles. This led to the development of its

strategy of emphasizing the drive-through as a major engine of growth. The company had to

develop relationships with Chinese governmental authorities and had to consider how local

customs and preferences affected its menu offerings. Wal-Mart faced similar challenges in

Mexico, particularly in terms of lifestyle differences and the adaptation of its distribution

strategies to the Mexican economy. Both companies faced competition from other multi-

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national corporations and from local firms.

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 Agriculture). This agreement enabled the company to receive agricultural

subsidies. The Mexican government allowed Wal-Mart to move into the banking arena.

This was in contrast to the opposition the company faced in the United States for the same

strategy.

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.

5. Numerous examples can be found in the Wall Street Journal and other business publications.

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