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 economythe 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.
. !utputs 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. "irms# use of these inputs is related to the
demand for their products.
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$. %he four ma&or types of markets are perfect competition, monopolistic competition,
oligopoly, and monopoly. %he key characteristics that distinguish these markets are '1( the
number of firms competing with each other, '( whether the products sold in the markets are
differentiated or undifferentiated, '$( whether entry into the market by other firms is easy or
difficult, and ')( the amount of information available to market participants.
). 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.
+ach 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 ,uantity- if they lower the price, consumers will increase the ,uantity
demanded.
.. In macroeconomics, the five ma&or categories of spending are consumption 'C(, investment
'I(, government 'G(, e/port 'X(, and import 'M(. GDP 0 C 1 I 1 G 1 X 2 M. %he first four
categories are added together, while import spending is subtracted because it represents a
flow of e/penditure out of the domestic economy to the rest of the world.
3. "iscal policies are implemented by the national government and involve changing ta/es 'T(
and government e/penditure 'G( to stimulate or slow the economy. %hese decisions are made
by the political institutions in the country. Monetary policies are implemented by a country#s
central bankthe "ederal 4eserve in the 5nited 6tates. %hese 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. 7hen 7al*Mart e/panded into Me/ico, it had to confront potential resentment from
Me/icans 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,
89%8:, and local bosses, the caci,ues. %he company also had to adapt to local customs,
which included finding native*speaking employees and broadcasting announcements in
native Indian languages.
. In 8pril, ;;<, the +conomist Intelligence 5nit predicted that Me/ico#s annual =:> growth
would gradually accelerate toward a rate of $.. percent. ?owever, Me/ico#s growth path
will continue to be dependent on the 5.6. economic cycle. 5.6. growth affects not only
Me/ican gross fi/ed investment and e/ports, but also its employment, wages, and private
consumption. Me/ican economists state that Me/ico is the most e/posed country in the
world to a 5.6. slowdown. !ne of the ma&or impacts on the Me/ican economy is the
remittance of money from Me/ican immigrants working in the 5nited 6tates back to
Me/ico. %he Central @ank of Me/ico reported in May ;;< that remittances from the
5nited 6tates dropped .A percent for the first ,uarter of ;;< compared with the same
period in ;;B. @y fall ;;<, the weaker 5nited 6tates economy was lowering Me/ico#s
growth rate. %he Me/ican government cut its estimate for =:> growth from .< percent to
.) percent. %he Me/ican central bank also cooperated with the 5nited 6tates "ederal
4eserve to increase li,uidity in the financial system. 6ee CMe/icoD Country "orecast
6ummary,E EIU ViewsWire, 8pril 1B, ;;<- Fane @ussey, CMe/ico "eels !ur +conomic
>ain,E McClatchy-Tribune Business News, 8pril B, ;;<- Miriam Fordan, C"ewer Gatino
Migrants 6end Money ?ome, >oll 6ays,E Wall Street !urnal, May 1, ;;<- C8 6lowing
Me/ican +conomy,E EI" ViewsWire, 6eptember $, ;;<- and CCrisis Management in
Me/ico,E EI" ViewsWire, 9ovember 1, ;;<.
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$a. %his 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 ,uantity in the entire
market, not the decisions of individual producers. It describes the e/pectation that current
high prices will give soybean farmers the incentive to increase production in the future.
b. %his paragraph is a description of interdependent oligopoly behavior. =eneral Motors#
strategy of rebates and zero percent financing is matched by "ord and :aimlerHChrysler.
!ligopoly firms develop their strategies by anticipating the possible responses of their
rivals.
c. %his discussion describes the attempt by the 5.6. wireless telecommunications industry
to gain monopoly or market power through mergers of independent firms. %he paragraph
notes that the traditional phone industry did have a period of monopoly status when the
industry was highly regulated. %he monopoly power of the wireless industry is under
constant attack from new technologies and an increase in new entrants into the market.
+ven the merged firms will find their monopoly power under attack.
d. Chinese restaurants represent monopolistic competition. %here are $3,;;; Chinese
restaurants, most of them small, family operations. 9o national chain dominates these
restaurants, largely due to the use of the wok for cooking. 6pecialized stoves and chefs
are re,uired for this type of cooking, which has limited the e/pansion of these firms into
large*scale production.
). 9umerous e/amples 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. "irms with market power often use all types of strategies. "or e/ample, many
restaurants responded to the economic slowdown in ;;B and ;;< by scaling back
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e/pansion plans, skimping on items like e/tra sauce and free sour cream, closing sites, and
laying off workers. 8fter e/amining rivals# portions of hash browns and french fries and
analyzing leftovers, Iicorp, which owns );;*plus Iillage Inn and @akers 6,uare restaurants,
cut back as much as an ounce from each serving of these foods with a pro&ected annual
savings of more than J.;;,;;;. 6ee Feffrey McCracken and Fanet 8damy, C4estaurants "eel
6ting of 6urging Costs, :ebt,E Wall Street !urnal, 8pril ), ;;<.
.. +/amples of these types of strategies are discussed in Chapter 1). "irms 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. :emand increases 'assuming that computers are a normal good(.
b. %here is a decrease in the ,uantity demanded of computers 'and no change in the demand
curve(.
c. :emand increases, as the price of a complementary good has fallen.
d. %here is no change in demand, as semiconductors are an input to computer production and
thus a determinant of supply.
e. :emand decreases in !ctober, as consumers wait to buy at a lower price in :ecember.
. a. 6upply increases.
b. 6upply decreases.
c. %here is a decrease in the ,uantity of supplied computers 'and no change in the supply
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curve(.
d. 6upply decreases 'because costs of production have increased(.
e. %here is no change in supply, as consumer incomes are a determinant of demand.
$. a. X is a normal good. 7e know this because there is a positive relationship between
income and the ,uantity demanded of good X.
b. X and # are substitutes. 7e know this because there is a positive relationship between the
price of good # and the demand for good X 'thus, as the price of # rises, consumers buy
more X(.
c. X and $ are complements. 7e know this because there is a negative relationship between
the price of good $ and the demand for good X 'thus, as the price of $ rises, consumers buy
less X(.
d. %
D
0 .;; 2 .P
X
1 ;..I 1 1;P
#
2 P
$


0 .;; 2 .P
X
1 ;..'$;( 1 1;'1;( 2 ';(


0 .B. 2 .P
X
e. >rice intercept 0 J11.- Kuantity intercept 0 .B.- 6lope 0 *;..
f. %he ,uantity demanded is .;;.
g. %he e,uation of the demand curve is
%
D
0 3. 2 .P
X
>rice intercept 0 J1.- Kuantity intercept 0 3.- 6lope 0 *;..
). a. X and $ are complements in production. 7e know this because there is a positive
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relationship between the price of good $ and the supply of good X 'thus, as the price of $
rises, producers produce more X(.
b. %
S
0 2;; 1 ;P
X
2 .P
I
1 ;..P
$
0 2;; 1 ;P
X
2 .'1;( 1 ;..';(
0 2); 1 ;P
X
c. >rice intercept 0 J1- 6lope 0 ;.;.. 6ee te/t answers for graph.
d. 6et %
S
0 ;. %he minimum price is J1.;;.
e. %
S
0 2); 1 ;'.( 0 3;.
f. %
S
0 2;; 1 ;P
X
2 .'.( 1 ;..';( 0 21. 1 ;P
X
- >rice intercept 0 J1;.B.- 6lope 0 ;.;..
.. a. :emand curveD >rice intercept 0 J.;- Kuantity intercept 0 .;;. 6upply curveD >rice
intercept 0 J$$.$- 6lope 0 ;.$$.
b. %L 0 3;- PL 0 1;.
c. 8t P 0 J1;;, the ,uantity demanded is $;;, while the ,uantity supplied is ;;. %hus,
there is a shortage, and the market price will rise.
d. 8t P 0 J1.;, the ,uantity demanded is ;;, while the ,uantity supplied is $.;. %here is a
surplus, and the market price will fall.
e. PL 0 1);- %L 0 $;. 9ew demand curveD >rice intercept 0 J$;;- Kuantity intercept 0
3;;.
3. a. :emand increases 'the price of a substitute has risen(- e,uilibrium price and ,uantity rise.
6ee te/t answers for graphs.
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b. 6upply decreases 'the price of an input has risen(- e,uilibrium price rises and ,uantity
falls.
c. :emand increases- e,uilibrium price and ,uantity rise.
d. 6upply increases- e,uilibrium price falls and ,uantity rises.
e. :emand decreases- e,uilibrium price and ,uantity fall.
B. a. %he 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(. 7ith no further
information, we know that the e,uilibrium price will fall, but the effect on ,uantity cannot
be determined.
b. %he rise in gasoline prices will cause demand to decrease, which will cause the ,uantity
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 ,uantity to rise(, then we may now be
able to conclude that the e,uilibrium ,uantity of automobiles is likely to fall.
<. a. @ecause hamburger is an inferior good, demand will increase as incomes decrease, causing
the price to rise 'rightward shift of demand curve(. %he improvement in technology that
lowers production costs causes supply to increase and tends to lower price 'rightward shift
of supply curve(. 7ith no further information, we know that the e,uilibrium ,uantity will
rise, but the effect on price cannot be determined. 6ee te/t answers for graphs.
b. %he 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 e,uilibrium price of hamburger is
likely to fall. 6ee te/t answers for graphs.
Application Questions
1. %he supply of copper had decreased 'leftward shift of the supply curve( due to strikes which
halted production in ;;3. Continuing demand from China was e/pected to shift the demand
curve to the right, although the world*wide recession in ;;< might impact this demand.
%he 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.
. %he boom in copper and other commodity prices continued through the first half of ;;<.
%hese high prices put immense pressure on geologists and engineers in ma&or mining
companies to find new sources of copper, often in remote areas such as the >eruvian 8ndes.
@y 8pril ;;<, 4io %into employed A.; e/plorers worldwide and spent 1. percent more on
e/ploration than it did five years earlier. Many global mining companies were playing
catch*up after a long period of underinvesting in e/ploration for new mines. ?owever, it can
take years to get a new mine up and running. %he high copper prices also continued to make
manhole covers, pipes, wiring, and even public art pro&ects made of bronze 'whose main
ingredient is copper( the targets of theft in many 5.6. cities. ?owever, in summer and fall
;;<, the prices of copper and other commodities fell in response to the slump in global
demand. 6ee 4obert =uy Matthews, C?unters Comb =lobe for a ?ot Metal,E Wall Street
!urnal, 8pril ), ;;<- 6arah Mc@ride, CCopper CaperD %hieves 9ab 8rt to 6ell for 6crap,E
Wall Street !urnal, May 1, ;;<- 8llen 6ykora, CCopper is Iulnerable to "alling "urther,E
Wall Street !urnal, 9ovember ), ;;<.
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$.a. '1( 8n une/pected supply glut is an increase in supply. %his is represented by a rightward
shift of the supply curve, which drives down the e,uilibrium price and increases the
e,uilibrium ,uantity. '( 8 slowdown in the economy or housing market causes a decrease
in the demand for wood products. %he demand curve shifts to the left, resulting in a lower
e,uilibrium price and ,uantity. '$( %he unusually hot weather causes construction delays,
which also decreases the demand for wood products 'leftward shift of the demand curve(.
')( %he slackened demand in the 8sian markets also causes the demand curve for wood
products to shift to the left, resulting in lower prices.
b. %he e/cerpts discuss a possible slowdown in the entire economy or in the housing
sector, one of the ma&or sectors influencing overall economic activity. %he "ederal
4eserve '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. >rices in the wood products industry were e/pected to
recover as long as the "ederal 4eserve did not raise interest rates significantly. "oreign
demand from 8sian markets is also part of the macroeconomic environment.
c. %he wood products industry is composed of Cthousands of producers who
fre,uently manufacture e/cess ,uantities.E %his 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. %he e/cerpts 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.
).a. %he new demand for ethanol and biodiesel has raised the prices of corn, palm oil, sugar,
and other crops from which these products are made. ?owever, 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. %hese
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. %echnological 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. 4ising incomes, particularly in China, increase the demand for food, resulting in higher
food prices.
e. 8 bumper crop, or a large increase in the supply of various commodities, may be
necessary to keep food prices lower in India and China.
..a. >rices in the chicken market had been low relative to the costs of production. %he
increased costs of production have caused a decrease in supply 'leftward shift of the
supply curve(. %his change, combined with increased seasonal demand for chicken
'rightward shift of the demand curve( has caused chicken prices to rise.
b. %he diversion of corn to make ethanol has increased the price of corn. %his increase
combined with soybean*meal price increases led to higher production costs for chickens.
?igher production costs caused a decrease in the supply of chickens and chicken prices to
increase.
Chapter 3
Technical Questions
1. a. >rice elasticity 0 21 'unitary elasticity(
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b. >rice elasticity 0 2..) 'elastic(
c. >rice elasticity 0 2;..) 'inelastic(
. a. >rice elasticity 0 21 'unitary elasticity(
b. >rice elasticity 0 2$.; 'elastic(
c. >rice elasticity 0 2;.$$ 'inelastic(
$. a. 4evenue will rise because demand is inelastic. 8 1; percent price increase will cause the
,uantity demanded to fall by . percent, but that will be more than offset by the 1; percent
increase in price on the units that are still sold.
b. 4evenue will rise because demand is elastic. 8 . percent price decrease will cause the
,uantity demanded to rise by 1.. percent, and that will more than offset the lower price on
the original units.
c. 4evenues will not change. @ecause elasticity is 21, a 1 percent increase in price will
result in a 1 percent decrease in ,uantity demanded, and thus revenue will not change.
d. 4evenues will rise. @ecause demand is perfectly inelastic, there will be no change in the
,uantity demanded when price increases, and, thus, revenues will increase.
). a. P
X
0 .; 2 1H%
T& 0 P% 0 '.; 2 1H%(% 0 .;% 21H%

b. 6ee te/t answers for graphs.

c. 8t % 0 .;, M& 0 ;, and, thus, revenue is ma/imized. 8t that point, P 0 J1., and, thus,
T& 0 J$1,.;.
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d. %he midpoint of the demand curve is at % 0 .;, P0 J1.. 8bove that point, demand is
elastic, and below that point, demand is inelastic.
.. :emand is elastic 'and, thus, revenues will fall if you increase the price and rise if you
lower it(. Mour good is a normal good and is income elastic 'or a lu/ury good(. %he related
good is a complement because a rise in the price of the other good causes a decrease in
demand for your product- the goods are fairly strong complements, as the demand for your
product is elastic with respect to the price of the other good.
3. :emand is inelastic 'and, thus, revenues will rise if you increase the price and fall if you
lower it(. Mour good is a normal good and is income inelastic 'or a necessity good(. %he
related good is a substitute because a rise in the price of the other good causes an increase in
demand for your product- the goods are fairly good substitutes as the demand for your
product is elastic with respect to the price of the other good.
Application Questions
1.a. %he short*run price elasticity of demand is *;.;3 '*;.3N H 1;N(, while the long*run price
elasticity is *;.) '*)N H 1;N(. 8s e/pected the short*run price elasticity is smaller than the
long*run price elasticity because consumers have more time to change their behavior over
the long run. %he income elasticity of demand is ;.. '*;..N H *1N(. =asoline is a normal
good with a positive income elasticity of demand 'as income increases, gasoline demand
increases and vice versa(.
b. %he Congressional @udget !ffice 'C@!( report, E''ects !' Gas!line Prices !n Dri(in)
Beha(i!r an* Vehicle Mar+ets, was based on four years of data collected from metropolitan
freeways in California from ;;$ to ;;3. %he 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 ad&acent to commuter rail systems which showed slightly
greater ridership. %he C@! also found that a ; percent increase in gasoline prices resulted
in a .3 percentage point increase in the market share of new cars. 8ll ma&or car categories
gained market share. ?owever, the market share of all types of light trucks, from minivans
to 65Is to pickup trucks and passenger or cargo vans, fell by ) to 3 percent.
c. =iven the above income elasticity, the weak economy contributed to decreasing the demand
for gasoline. %he housing market slump was also a factor as consumers had less home
e,uity to finance their e/penditures. %hese changes also caused consumers to buy more fuel*
efficient cars.
. 7e can use the facts in the ,uestion to make inferences about the price elasticity of demand
for walk*up, unrestricted business airfares.
a. !n the Cleveland2Gos 8ngeles route, the decrease in fare resulted in about the same
revenue as the higher fare. %his implies a consumer price elasticity of demand around 2
1.;;. 8t unit elasticity, any change in price results in no change in total revenue. !n the
Cleveland2?ouston route, the decrease in price resulted in less revenue, but greater market
share. :emand was inelastic on this route because ,uantity demanded increased as the
price was lowered, but total revenue decreased. :emand was price elastic on the ?ouston2
!akland 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
e/pectations. 8s discussed in the chapter, the airlines typically assumed that demand for
business travel was inelastic, while demand for leisure travel was elastic. 5nder 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. +mployees began searching for lower restricted fares that would meet their
schedules or using videoconferencing or driving as a substitute for air travel. %he terrorist
attacks on 6eptember 11, ;;1, also had a ma&or 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. 8ll of these factors resulted in ma&or changes in
business traveler behavior and a probable increase in their price elasticity of demand. %he
above market tests show that business demand is actually price elastic in certain markets.
$. >ublic health officials advocate the use of cigarette ta/es to reduce teenage smoking because
the data in %able $.B show that the teenage price elasticity of demand for cigarettes is
appro/imately 1 or higher in absolute value. %hus, demand is unit or even price elastic.
%eenagers are sensitive to the price of cigarettes and will reduce or ,uit smoking in response
to the ta/es imposed on cigarettes. Cigarette ta/es are a good source of revenue for state and
local governments, given that the price elasticity of demand for adults is inelastic. %his
means that an increase in price results in an increase in total revenue, given that the
percentage change in ,uantity is less than the percentage change
). 8 price elasticity of demand for urban transit between 2;.1 and 2;.3 means that demand is
inelastic for transit users. %hus, increased fares will result in higher revenue for local
governments and transit authorities. %his is the economic argument for raising transit fares.
?owever, there may be political constraints on raising fares. %he inelastic demand may result
from the low income levels and lack of automobiles and other substitute forms of travel of
transit riders. Ioters may perceive increased fares as placing an unfair burden on these low*
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income riders. %ransit authorities often obtain voter approval for new transit systems by
promising not to raise fares for a certain number of years. =overnmental decisions are
typically based on many factors other than economic arguments.
.. Information for case studies can be found in sources such as the followingD @utscher ,
6tephan 8. C!nsu,er -!yalty Pr!)ra,,es an* Clubs, 8ldershot, 5O and @urlington, I%D
=ower, ;;- @asso GF, Clements M%, 4oss %7. Moral ?azard and Consumer Goyalty
>rograms. ",erican Ec!n!,ic !urnal. Micr!ec!n!,ics ;;A- 1 '1(D 1;1*1$.
3. %he 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. %here are more substitutes for the product of an
individual firm than for the product overall. %his outcome is most clearly shown in %able $.B
for agricultural products. %he 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 2<;; to 2$1,;;; 'e/tremely elastic(. %he price elasticity of demand
for individual physicians is also much larger than that for medical or dental care as a
commodity. %he 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.
B. +@ay has been shifting the site#s emphasis away from auctions and toward fi/ed*price
listings in response to increased competition from 8mazon.com and other rivals. %he
company reduced the charge to post items and increased what it collected when an item sold.
%he 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. +@ay also offered fee discounts to their best*rated sellers. 6eeD
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=eoffrey 8. "owler, C8uctions "ade in e@ay#s @id for =rowth,E Wall Street !urnal, May
3, ;;A.
<. %he 5.6. >ostal 6ervice raised >riority Mail rates by 13 percent, and @ear Creek Corporation
reduced its package shipping by 1. to ; percent. %he implied price elasticity of demand
'N%HNP( ranges from 21.H13 0 2;.A) to 2;H13 0 21... If this response is typical for all
>ostal 6ervice customers, revenues will either remain appro/imately the same or decrease,
given that the price elasticity of demand is appro/imately unitary or price elastic.
>articularly if the demand is elastic, the >ostal 6ervice will not be able to reduce its deficit
by this strategy because revenues will decrease. Consumers will use "ederal +/press or 5>6
instead of the >ostal 6ervice to ship their packages.
Chapter 4
Technical Questions
1.a.7endy#s was trying to determine consumer preferences for a new product, the vanilla
"rosty, to appeal to younger diners. %he company brought more than 1;; consumer testers
to its head,uarters to sample different flavors of vanilla. 8lthough the company ran the risk
of alienating e/isting customers with the new "rosty, sales increased .N after 7endy#s
introduced the vanilla "rosty.
b. Oraft "oods had to develop a new !reo to sell in China because traditional !reos were too
sweet and too e/pensive for the Chinese market. %he company tested ; 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 8merican tradition of pairing
milk with cookies to increase the demand for !reos.
c. "isher*>rice had to adapt its toys to consumer preferences in developing international
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markets. %he company had to focus on local customs and traditions so that it did not alienate
consumers in these countries.
. %he plotted data are simply price and ,uantity combinations for each of the 1; years.
8lthough the data appear to indicate a downward sloping demand curve for potatoes, many
factors other than the price of potatoes changed over this period. %hese 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 "rench
fries at fast*food outlets. %hus, 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. %o
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. !nce
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 ,uantity demanded,
all else held constant.
$. %he sign of the regression coefficient 'B( shows the effect of the variable on the demand for
hotel rooms, while a t*statistic greater than .; supports the hypothesis that the variable is
significantly different from zero. %he regression results indicate that the most important
hotel room attributes for business travelers were price, room ,uality, a guaranteed
reservation, the availability of a nonsmoking floor, and the availability of free parking.
+/cept for price, which was negatively related to ,uantity demanded, all other significant
variables had a positive effect on demand. %he low t*statistics on the variables measuring the
,uality 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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). 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. %he regression coefficients then show the effect of each variable, while statistically
holding constant the effects of all other variables. @ecause each study is based on a limited
set of data, researchers want to be able to generalize the results. %herefore, 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. %he variable does not have an effect on demand
in the larger population. +conomic theory may give the researcher some knowledge of the
e/pected sign of the variable 'i.e., a price variable should have a negative coefficient in a
demand e,uation(. In many cases, however, the researcher does not know the e/pected sign
of the variable, so the test is simply to determine whether the variable is significantly
different from zero.
Application Questions
1. %he recession of ;;< and lack of demand for its cars forced =eneral Motors Corp. to
declare bankruptcy in Fune ;;A. =M announced it would close 1B factories and parts
centers and cut ;,;;; more &obs by the end of ;11. !ver the years =M had developed too
many brands and was locked into high costs from its management, marketing, and labor
practices. Mears of heavy sales incentives had also decreased its profit margins. 6eeD 9eil
Oing Fr. and 6haron %erlep, C=M Collapses Into =overnment#s 8rms,E Wall Street !urnal,
Fune , ;;A- Fohn :. 6toll, Oevin ?elliker, and 9eal +. @oudette, C8 6age of :ecline and
:enial,E Wall Street !urnal, Fune , ;;A.
S-19
. %est marketing and price e/periments can be established so that consumer characteristics in
addition to price, such as income and other demographics, can be varied in the different
settings. %hus, 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
e/periments. %hus, test marketing, price e/periments, focus groups, and laboratory
e/periments can be constructed to vary one characteristic 'usually price(, while holding other
factors constant. Multiple regression analysis accomplishes this same task statistically. 7hen
variables are entered into a multiple regression analysis e,uation, their effects are statistically
held constant. +ach 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
e,uation constant.
$. 5sing e/pert 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. +/perts may also have a limited view of the entire
set of factors influencing consumer demand. 7ith 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 e/periment 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 e,uations or if irrelevant variables are included. Met appropriate data may not be
available for all relevant variables. %here can also be problems interpreting the effects of
individual variables if the variables in the e,uation are highly correlated with each other.
S-20
). %he estimating e,uation included variables measuring the monetary price of the cars as well
as variables measuring the search costs of subse,uent visits to a dealer and whether a
consumer repurchases the same brand of vehicle 'which lowers search costs(. @ecause 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
&ust the monetary price.
.. 8ll the coefficients in the table are significantly different from zero because their t*statistics
are greater than .;. %hus, all the variables affect the demand for prescription drugs in this
data sample. %he price coefficient has a negative sign, as e/pected, while the income
coefficient is positive, indicating that these drugs are normal goods. 8n increase in the
number of doctors in a country has a positive effect on demand, as e/pected. %he time trend
variable has a positive coefficient, indicating that demand changes over time due to variables
not e/plicitly included in the e,uation. 8ll of the country variables have negative
coefficients, showing that drug consumption in all of these countries is less than that in the
5nited 6tates. %his study is not too useful for managerial decision making because it was
done at a very aggregate level. %he price and ,uantity variables represent e/penditure for an
entire country. %he 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
e/penditure. %his more*detailed disaggregated information could be used for strategic
decision making.
Chapter
S-21
Technical Questions
1.a.
Capital 'O( Gabor 'G( %otal >roduct
'%>(
8verage
>roduct '8>(
Marginal
>roduct 'M>(
1; ; ; ** **
1; 1 . . .
1; 1. B.. 1;
1; $ $; 1; 1.
1; ) .; 1.. ;
1; . B. 1. .
1; 3 <. 1). 1;
1; B A; 1.A .
1; < A 11..
1; A A 1;. ;
1; 1; A; A *
b. 6ee shapes of graphs in "igure ..1 in the te/t.
c. 8fter the fifth worker 'or output of B.(, there are diminishing marginal returns.
d. 8verage product is ma/imized at an output level between B. and <. 'between . and 3
workers(.
.a.
Total A!era"e #ar"inal
Capital $K% &abor $L% Product $TP% Product $AP% Product $MP%
1; ; ;
1; 1 . . .
1; 1;; .; B.
1; $ ; B$ 1;
1; ) $;$ B3 <$
1; . $.B B1 .)
1; 3 $A 3. $.
S-22
1; B )1) .A
1; < )) .$ 1;
1; A )< )< )
1; 1; )A )$ 1
b. 6ee te/t answers for graphs.
c. 8fter the third worker 'or output of ;(, there are diminishing marginal returns.
d. 8verage product is ma/imized at an output level of $;$.
$. a. +/plicitD lease, inventory, wages, electricity, insurance.
ImplicitD Fim#s forgone salary and the forgone interest on his savings.
b. "i/edD Gease, insurance.
IariableD Inventory, wages, electricity 'probably varies with output(.
). a. 8ccounting profit is total revenue less e/plicit costs 0 J1.;,;;; 2 P.,;;; 1 1,;;; 1
$;,;;; 1 ;,;;;Q 0 J1.;,;;; 2 <B,;;; 0 J3$,;;;.
b. +conomic profit 0 total revenue 2 e/plicit costs 2 implicit costs
0 J1.;,;;; 2 <B,;;; 2 .;,;;; 2 .,;;; 0 J<,;;;
..a
O G %> %"C %I
C
%C 8"C 8IC 8%C MC
1; ; ; ;; ; ;; ** ** ** **
1; 1 . ;; 1; 1; );.;; .;; ).;; .;;
1; 1. ;; ; ; 1$.$$ 1.$$ 1).33 1.;;
1; $ $; ;; $; $; 3.3B 1.;; B.3B ;.3B
1; ) .; ;; ); ); ).;; ;.<; ).<; ;..;
1; . B. ;; .; .; .3B ;.3B $.$) ;.);
1; 3 <. ;; 3; 3; .$. ;.B1 $.;3 1.;;
1; B A; ;; B; B; . ;.B< $.;; .;;
1; < A ;; <; <; .1B ;.<B $.;) ..;;
b. 6ee "igure .. in the te/t.
c. 8verage total cost is minimized at an output level of appro/imately A1. 8verage variable
cost is minimized at an output level of appro/imately <;.
S-23
3. a.
' & #P(TP TFC T)C TC AFC A)C ATC #C
1; ; H; .;; ; .;;
1; 1 .H. .;; ; .; ; ;.<; ;.<; ;.<;
1; B.H1;; .;; ); .); . ;.); ..); ;.B
1; $ 1;H
;
.;; 3; .3; .B ;.B ..) ;.1B
1; ) <$H$;$ .;; <; .<; 1.3. ;.3 1.A1 ;.)
1; . .)H$.B .;; 1;; 3;; 1.); ;.< 1.3< ;.$B
1; 3 $.H$A .;; 1; 3; 1.< ;.$1 1..A ;..B
1; B H)1) .;; 1); 3); 1.1 ;.$) 1... ;.A1
1; < 1;H)) .;; 13; 33; 1.1< ;.$< 1..3 .;;
1; A )H)< .;; 1<; 3<; 1.1B ;.) 1..A ..;;
1; 1; 1H)A .;; ;; B;; 1.13 ;.)B 1.3$ ;.;;
b. 6ee te/t answers for graphs.
c. 8verage total cost is minimized at an output level of appro/imately )1) 'or average total
cost of J1...(. 8verage variable cost is minimized at an output level of appro/imately $;$
'or average variable cost of J;.3(.
B. a 6ee "igure ..) in the te/t.
b. %he total product curve has a diminishing slope everywhere. @oth the marginal product
and average product curves are downward sloping with marginal product everywhere below
average product after their point of e,uality. %he total variable cost and total cost curves are
upward sloping everywhere. %he marginal cost and average variable cost curves are upward
sloping with marginal cost greater than average variable cost after their point of e,uality.
%he marginal cost curve intersects the average total cost curve at its minimum point.
<. 8n improvement in technology lowers 'shifts rightward( marginal cost and all other cost
S-24
curves 'e/cept fi/ed cost, which is not affected by marginal product(. %he minimum points
on the average total and average variable cost curves will be at higher outputs and lower
costs.
A. - 0 .;- "P
-
0 .;- MP
-
0 B.- P
-
0 J<;- T/C 0 J.;;.
a. "P 0 %H-
.; 0 %H.;
% 0 ,.;;
"VC 0 TVCH% 0 '<;('.;(H,.;; 0 ),;;;H,.;; 0 J1.3;
b. MC 0 P
-
HMP
-
0 <;HB. 0 J1.;B
c. "TC 0 TCH% 0 PTVC 1 T/CQH% 0 P),;;; 1 .;;QH,.;; 0 ),.;;H,.;; 0 J1.<;
d. '1( 7e donRt know if marginal cost is increasing or decreasing, as we have only one data
point. '( 8verage variable cost must be decreasing, as marginal cost is less than "VC. '$(
8verage total cost must be decreasing for the same reason.
Application Question
S-25
1. 7ith a given technology and fi/ed inputs, as employees at the drive*through windows
worked faster to achieve the goal of a A;*second turnaround time for a drive*through
customer, the ,uality of the service began to decline, and worker frustration and
dissatisfaction increased. %his situation represents diminishing returns as more
variable inputs are used relative to the amount of fi/ed inputs. %he management
response to these problems was to implement new technologies for the production
processD 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,
appro/imately .; Mc:onald#s franchises have been testing remote order*taking. 7ith
a remote call center, an order*taker can answer a call from a different Mc:onald#s
where another customer has already pulled up.
. a. %here will be diminishing returns in the drug manufacturing process because much of the
testing for ,uality, gauging of dryness, and testing for bacterial contamination is done by
hand. %here are bottlenecks in terms of the fi/ed inputsbatches of chemicals that must
be dried, the use of microscopes to count organisms. 8dding more workers to the
production process without increasing the fi/ed inputs will result in diminishing returns.
b. %he ":8 allowed firms to maintain these types of production processes to maintain the
,uality and safety of the drugs. >ursuing this goal made the pharmaceutical companies
very hesitant to change the production process and adopt new technologies because any
change would re,uire new ":8 approval. %he time and paperwork involved would
probably put the company at a competitive disadvantage.
S-26
$.a. ?olding an inventory of shirts creates capital costs in terms of the warehouses needed. If
these buildings are owned by >enney#s, there is an implicit cost of using them to hold
inventory. >enney#s managers decided it was more efficient to avoid these costs by
contracting with %8G 8pparel Gtd. to directly supply its stores.
b. %his innovation also helps demand management because %8G collects point*of*sales data
directly from the >enney#s stores and then uses a forecasting model to decide how many
shirts to make and in what styles, colors, and sizes. %he shirts are then sent directly to the
>enney#s stores. %his approach helps to match production and demand and minimizes
inventory costs.
). 8 change in a firm#s total fi/ed costs of production will shift its average total cost '"TC(
curve because "TC 0 "/C 1 "VC and "/C 0 T/CH%. %hus, an increase in total fi/ed cost
will shift up the average total cost curve. "i/ed costs do not influence the marginal costs of
production. MC 0 TCH% 0 TVCH%. Marginal cost is influenced only by the variable
costs, as fi/ed costs, by definition, do not change.
.. In a short*run production process, the marginal cost curve eventually slopes upward due to the
onset of diminishing returns in the production function. 8s 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. 8ny change in input prices causes a shift in
the cost curves, not a movement along them.
Chapter *
S-27
Technical Questions
1. 8 company operates plants in both the 5nited 6tates 'where capital is relatively cheap and
labor is relatively e/pensive( and Me/ico 'where labor is relatively cheap and capital is
relatively e/pensive(.
a. %he cost*minimizing choice depends on the ratio of the marginal productivity of the input
relative to the cost of the input in each country. @ecause input costs are very different in the
two countries, it is probable, all other things held constant, that in the 5nited 6tates the firm
will choose an input mi/ consisting of a lot of capital and relatively little labor and that in
Me/ico it will use relatively more labor and less capital.
b. If the factors of production cannot be substituted, the input mi/ will have to be identical.
8dditionally, if input productivities vary between countries, the input choice may be similar
'for e/ample, if 5.6. labor is e/pensive, but highly productive, the firm will use a lot of
labor in the 5nited 6tates as well(.
. 6ee te/t answers for graph.
$. Industry studies often suggest that firms may have long*run average total cost curves that
show some output range over which there are economies of scale, a wide range of output
over which long*run average cost is constant, and, finally, a very high output range over
which there are diseconomies of scale.
a. 6ee graph for "irm @ in "igure 3.$ in the te/t. %he minimum efficient scale occurs where
the long*run average cost curve reaches its minimum point
S-28
b. @ecause there is a wide range of output over which firms have identical costs, firms need
not be the same size to be efficient. %hus, in an industry like this, there could be firms of the
same scale or of very different scales of production.
). a. %he minimum efficient scale should be at a high level of output.
b. %he minimum efficient scale should be at a low level of output.
6ee te/t answers for graphs.
.. a. %he iso,uants are shaped like right angles with the point at one worker and one unit of
capital.
b. %he iso,uants are downward sloping straight lines.
c. %he iso,uants are the normal shape with a diminishing marginal rate of technical
substitution.
3. a. 6ee te/t answer for graph.
b. 6ee te/t answer for graph.
B. a. P
-
0 J., P
0
0 J..
b. 7hile we cannot determine the firm#s precise input choice without knowing the production
function, the isocost curve will pivot on the O*a/is at O 0 1;; and get steeper as the wage
rate rises. %he firm will not be able to produce the current level of output with the same total
cost of production. 7ith a higher cost of production 'new isocost line(, the optimal input mi/
will use relatively less labor and relatively more capital.
<. a. In the short run, with fi/ed capital, the firm cannot change its input mi/ because capital is
fi/ed. %hus, the firm must employ e/actly the same inputs if it wishes to produce the same
S-29
,uantity of output. ?owever, the total cost of production will increase 'new isocost line(.
b. %he 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 mi/ with less
labor and more capital. '9ote also that the rise in costs may reduce the ,uantity that the
firm wishes to produce.( %he total cost of production will increase in order to produce the
original level of output, but not by as much as when the input mi/ was held constant 'part
a(. 6ee te/t answers for graphs.
Application Questions
1. @ecause %oyota was building a new plant, it could incorporate the latest technology into its
production process and design an efficient small plant. %he %oyota plant covered . million
s,uare feet compared with the $.B. million*s,uare*foot =eneral Motors plant. %oyota also
arranged for 1 suppliers to set up factories on the same site. =M had e/isting agreements
with suppliers who were located elsewhere and union contracts that prohibited it from using
lower*paid non*union workers to cut costs. %oyota was able to plan out the optimal sized
plant.
. ?.F. ?einz is developing sweeter tomatoes for its ketchup in response to the soaring price of
high*fructose corn syrup which accounts for about 1;N of the cost of producing a bottle of
ketchup. ?einz is paying .N more for its corn syrup that it did two years ago. %omatoes,
which account for a third of the cost of making a bottle of ketchup, have also become more
e/pensive with the cost of growing an acre of tomatoes increasing from J1,<;; to J,$;;.
?einz has increased its budget for seed research and doubled the size of its seed research
team to $; people. 8lthough the company has long focused on increasing tomato yields, it
S-30
began putting an emphasis on developing sweeter tomatoes in the past two years as corn
prices began rising. 'S!urceD Fulie Fargon, C6eeking 6weet 6avings,E Wall Street !urnal,
!ctober , ;;B.(
7hen the %ed 6tevens 8nchorage International 8irport was planning a new concourse,
8laska 8irlines insisted that the Cone thing we don#t want is a ticket counter.E 7hen
Concourse C opened in ;;), it had only one, small traditional ticket counter for the 1.
million passengers that checked in that area in that year. %he new design with self*service
check*in machines and manned Cbag dropE stations doubled 8laska#s capacity, halved its
staffing needs and cut costs while speeding travelers through the building in far less time.
!ther airlines and other airports have copied these design changes to try to increase
productivity and reduce costs. 'S!urce. 6usan Carey, CCase of the Ianishing 8irport Gines,E
Wall Street !urnal, 8ugust A, ;;B(
$.
S-31
$
0
!utput
'millions
of barrels(
1.5
8.0
SRAC
LRAC
'6ourceD Oenneth =. +lzinga, Chapter ), C@eer,E in 7alter 8dams and Fames 7. @rock
'ed.(, %he 6tructure of 8merican Industry, 1;
th
ed., >rentice*?all, ;;1.(
a. +conomies of scale are substantial up to a plant capacity of 1.. to .; million barrels of
beer per year. Costs continue to decline more modestly up to a capacity of appro/imately <
million barrels per year. %he long*run average cost curve is essentially flat beyond < million
barrels per year, so there are no further economies of scale.
b. %he firm with the 648C 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.
%he long*run average cost curve is the envelope curve of the short*run curves of firms with
the most efficient production. 6ince the 648C curve in the figure is not tangent to the G48C
curve, this firm did not have the most efficient production techni,ues even for its size.
). +conomies of scale suggest that large*scale production is cheaper than small*scale
production or that the long*run average cost curve slopes downward. ?owever, this large*
scale production is cheaper only if a large amount of output is produced and sold. %he huge
fi/ed costs of large*scale production lower the average cost of automobiles only if they are
spread out over a large number of autos. %he plant that lies at the minimum point of a 5*
shaped long*run average cost curve does not have the lowest costs if only a small number of
autos are produced. 8utomakers would be running plants at unprofitable rates if they did not
have a large market share. %his e/plains the behavior in the ,uote.
S-32
.. %hese results show that competition among a large number of plants and firms in the broiler
chicken industry is possible. %he minimum efficient scale of production is reached at a very
small percent of the entire market. %hus, 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 +
Technical Questions
1. a. In all three graphs, the profit*ma/imizing 'or loss*minimizing( output occurs where
marginal revenue e,uals marginal cost. In part 'a( the firm is not making a profit, as > S
8%C, but > T 8IC, so it is covering variable costs and, thus, should continue to produce in
the short run.
b. %he firm is making a profit because > T 8%C.
c. %he firm is not making a profit, as > S 8%C, and is not covering variable costs because >
S 8IC- thus, it should shut down..
.a.
A!era"e A!era"e
,umber Fi-ed )ariable Total #ar"inal )ariable Total
of .or/er 0utput Cost Cost Cost Cost Cost Cost
1ours $Q% $TFC% $TVC% $TC% $MC% $AVC% $ATC%
; ; 1.,;;; ; 1.,;;;
. 1;; 1.,;;; .B. 1.,.B. ..B. ..B. 1...B.
.; 1.; 1.,;;; A;; 1.,A;; 3..; 3.;; 1;3.;;
B. 1B. 1.,;;; 1,1;; 13,1;; <.;; 3.< A.;;
1;; 1A. 1.,;;; 1,B. 13,B. <.B. 3..$ <$.)3
S-33
1. ;. 1.,;;; 1,);; 13,);; 1..; 3.< <;.;;
1.; 1; 1.,;;; 1,.;; 13,.;; ;.;; B.1) B<..B
1B. 1 1.,;;; 1,.<. 13,.<. )..; B.)B B<.$
b. %he firm will produce ;. units.
c. %he firm#s profit is P'1..;(';.(Q 2 13,);; 0 ,.3..; 2 13,);; 0 2J1$.<$B..;. %he firm
is losing money, but if it were to shut down, it would lose J1.,;;; 'its fi/ed costs(- thus,
the loss*minimizing choice is to stay in business in the short run 'as P > "VC(.
d. 6ee te/t answer for graph.
$. 6ee "igure B. in the te/t. %he shutdown point is the point at which P 0 min "VC. %he
breakeven point is the point at which P 0 min "TC. %he firm#s short*run supply curve is the
marginal cost curve above the shutdown point.
). 6upply curve S

is more elastic than supply curve S

1
. 7e can infer this because, for a given
change in price, the change in ,uantity supplied is far greater on supply curve S

'in other
words, a given percentage change in price leads to a larger percentage change in ,uantity
supplied(.
.. a. %he industry is in long*run e,uilibrium if ,uantity supplied e,uals ,uantity demanded and
there are no firms that wish to enter or e/it the industry. In the representative graphs, firms
are &ust breaking even, so there will be no entry or e/it. 6ee "igure B.$ in the te/t.
b. %he increase in demand causes the price to rise to P

. %hus, marginal revenue rises for

the firms, and they will produce more and make a positive profit 'as P T "TC(.
S-34
c. >ositive short*run profits will induce more firms to enter the industry, given enough time.
%hus, industry supply increases, causing e,uilibrium price to fall and ,uantity to rise. %his
continues until the price falls to the original price, at which firms &ust break even, and there
is no further incentive for entry. %here will be more firms in the new long*run e,uilibrium,
but each firm will produce the original ,uantity '%
1
( and make zero economic profits.
3. a. %he decrease in demand causes the price to fall to P

. %hus, marginal revenue falls for the

firms, and they will produce less and make a loss 'as P < "TC(. 6ee te/t answer for
graphs.
b. Gosses will induce firms to e/it the industry, given enough time. %hus, industry supply
will decrease, causing e,uilibrium price to rise and ,uantity to fall. %his continues until
the price rises to the original price, at which firms &ust break even, and there is no further
incentive for e/it. %here will be fewer firms in the new long*run e,uilibrium, but each
firm will produce the original ,uantity '1
1
( and make zero economic profits.
B. a. %he short*run 8%C curve is tangent to the long*run 8C curve at its minimum point '%
E
23
but the short*run curve slopes up more steeply. %he 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 > 0 min 8%C 'K
+
( on the graph. If it is possible
to make a positive profit, more firms will enter- thus, price will fall as industry supply
increases. %his forces firms to produce at the efficient scale- otherwise, they will make a
loss, forcing e/it in the long run.
b. %he profit*ma/imizing output is found at the point where > '0 M4( 0 MC. If > T >
+
, the
short*run profit*ma/imizing output must be at a higher ,uantity than K
+
.
S-35
Application Questions
1. %here 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. %he
price is set by the market forces of demand and supply. %he 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. %his changed at the time of the article with the
formation of the 5nited >otato =rowers of 8merica.
%he response to high prices in the article is predicted by the model of perfect competition.
?igh prices and profits from the 1AA. crop caused farmers to plant far more potatoes in
1AA3. =iven favorable weather and insect conditions, this increase in supply resulted in a
drop in price from J<.;; to J.;; per 1;;*pound sack. @ecause this price was only about
one*third the cost of production, some farmers would plant fewer or no potatoes in the ne/t
cycle, shifting the supply curve to the left and driving price back up.
.a.%he greater number of uses for cranberries increases the demand for the product, resulting in
higher prices and greater profitability for cranberry producers.
b. %he factors creating a smaller crop of cranberries cause the supply curve to shift left,
resulting in higher prices. 7e can infer from the statement that the demand for cranberries is
probably inelastic, resulting in higher total revenue with the higher prices. %hus, profits
decline by a smaller percent than the decrease in cranberry production.
c. 8ll of these health*related factors associated with consuming cranberries will increase the
demand for the product, resulting in higher prices and profitability.
S-36
d. !cean 6pray has been using the health benefits of cranberries to develop and promote a
wider variety of cranberry drinks.
$.. %hese facts for the furniture industry are consistent with the model of perfect competition.
a. %he industry is composed of a large number of small firms. %hese
firms do not have the financial backing to make investments in new technology and
e,uipment, so they have difficulty increasing their productivity and lowering costs.
b. %hese data show that the industry is very unconcentrated. %he
three largest firms account for only ; percent of the market share, with the remainder split
among 1,;;; other manufacturers.
c. Capital spending by furniture manufacturers is low compared with
other manufacturing firms. %his means that furniture manufacturers use outmoded, labor*
intensive production techni,ues 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. %his range of options slows production and increases costs, also
causing a competitive disadvantage.
e. %here is ease of entry and e/it in the industry because there are no
significant economies of scale that could act as a barrier to entry.
f. 8s in other competitive industries, the furniture trade association
works to increase the demand for the entire industry.
g. "urniture manufacturers are attempting to work cooperatively in
S-37
the political arena to have the 5.6. government impose tariffs on Chinese imports, making
them more e/pensive and helping the 5.6. industry.
h. Changes in technology have made the furniture industry global
with competition from around the world.
). !verall, the statement is false. Information about a perfectly competitive firm#s fi/ed costs is
not needed to determine the profit*ma/imizing level of output. >rofit ma/imization occurs at
that level of output where marginal revenue e,uals marginal cost. In perfect competition, this
is also the point where price e,uals marginal cost. @ecause marginal cost shows the change
in total cost as output changes, it does not incorporate fi/ed costs. "i/ed costs are relevant to
determining the level of profit earned at that level of output. %he relationship between price
and average total cost determines whether profits are positive, zero, or negative. @ecause
"TC 0 "/C 1 "VC, fi/ed costs are relevant for determining the level of profit.
.. In a perfectly competitive industry, the market price is J.. 8 firm is currently producing
1;,;;; units of output, its average total cost is J<, its marginal cost is J;, and its average
variable cost is J;.
a. It is true that the firm is currently producing at the minimum average variable cost.
Marginal cost e,uals average variable cost of J;. =iven 5*shaped cost curves, the e,uality
of marginal and average variable costs occurs at the minimum point of the average variable
cost curve.
b. %he firm should produce more output to ma/imize its profit. 8t the current level of output,
the price of J. is greater than the marginal cost of J;. @ecause price e,uals marginal
revenue, the firm should increase output until marginal revenue e,uals marginal cost.
S-38
c. 8t the profit*ma/imizing level of output, average total cost will be less than the current value
of J< because MC S 8%C at the current output, so 8%C must be decreasing. >rofit
ma/imization occurs at the level of output where > 0 M4 0 MC 0 J..
Chapter 2
Technical Questions
1. 6ee "igure <.18 in the te/t.
. 6ee "igure <.1@ in the te/t. %he "TC curve must be above the demand curve at all points.
$. %he demand curve is %
D
0 .;; 2 P or P 0 .;; 2 %
D
. M& 0 .;; 2 %. %he monopolist has
constant marginal and average total costs of J.; per unit.
a. M& 0 MC
.;; 2 % 0 .;
).; 0 %
% 0 ., P 0 JB.
b. >rofit 0 T& 2 TC 0 'P('%( 2 '"TC('%( 0 'B.('.( 2 '.;('.( 0 J31,<B. 2 11,.; 0
J.;,3.
c. Gerner inde/ 0 'P 2 MC(HMC 0 'B.2.;(H.; 0 )..
). 6ee te/t answer for graph.
"or simplicity, assume that marginal cost is constant. >ersuasive advertising makes demand
more inelastic 'shifts from demand curve D
1
to D

(, and as elasticity decreases, the markup

S-39
over marginal cost 'and, thus, market power( is greater. ?owever, advertising also increases
fi/ed costs, and, thus, whether profit rises depends on the effectiveness of advertising
relative to its cost.
.. %he concentration ratio for Industry 8 is B;. %he concentration ratio for Industry @ is $A.
Industry 8 is more concentrated.
3. a. %he three*firm concentration ratio for Industry C is B., whereas it is A. for Industry :. In
both industries, the four*firm concentration ratio is 1;; because these firms account for
the entire market.
b. %he ??I inde/ in Industry C is ,.;;. %he ??I inde/ for Industry : is 3,..;.
c. 8lthough the four*firm concentration ratios are the same, the three*firm ratios and the
??I show that Industry : would be of more concern to antitrust authorities. %he ??I
inde/ is far higher due to the presence of one very large firm, which undoubtedly has
more market power than any of the four e,ually sized firms in the other industry. %hree
firms control A. percent of the market for Industry : and only B. percent for Industry C.
B. a. 6ee "igure <.)8 in the te/t. %he firm is currently making a profit.
b. @ecause there are no barriers to entry in a monopolistically competitive industry, positive
profits will induce entry. 8s more firms enter the industry, demand for each individual firm
will decrease until there are no more profits to be made. 8t that point, P 0 "TC for each
firm, and the industry is in long*run e,uilibrium. 6ee "igure <.)@ in the te/t.
<. +ffective advertising may increase demand and make it more inelastic. @ut it also increases
costs. %hus, advertising may lengthen the period during which the firm is able to make a
positive profit, but with demand decreasing due to the entry of other firms and costs rising,
S-40
in the long run, profits must be zero. 6ee te/t answer for graph.
Application Questions
1. In May ;;A, :ell Inc. reported a 3$ percent drop in ,uarterly profit and a $ percent
decline in revenue. %hese results were driven by weak business spending during the
previous three months and restructuring changes. :ell reported a ; percent decline in
laptop revenue and a $) percent decrease in desktop personal computers for the ,uarter.
?ewlett >ackard Co. also continued to e/perience weak results. 6eeD Fustin 6check, C:ell
7arns >C Market ?asn#t Met ?it @ottom,E Wall Street !urnal, May A, ;;A.
.a. 8s the article notes, In@ev hopes to gain from the economies of scale associated with the
takeover. %hese are both giant companies that would gain more market power from the
merger. %hey would be able to balance slow growth in mature markets with rapid growth
in emerging markets. @oth companies are interested in China, the world#s largest beer
market. %he role of financial markets as a barrier to entry is also discussed. In@ev has
been able to raise financial capital due to its size and credit rating even in financial
markets that are still very unsettled.
b. %here may be different cultures between the two companies that would cause problems for
a merger. In@ev may not be able to wring as much savings out of 8nheuser as it e/pects.
%here is already public resistance in the 5nited 6tates to the takeover of 8nheuser by a
foreign company. Member of the @usch family, who still run and hold stock in the
company, appear to be opposed to the takeover.
$. :rug companies fight to maintain their patents as long as possible to increase the
profitability of their drugs. %hey may engage in Cproduct switchingEretiring an e/isting
drug and replacing it with a modified version that prevents pharmacists from substituting a
S-41
cheaper generic for the branded drug. %here have been numerous lawsuits over patent
infringement.
). 7algreen is pursuing new strategies, given the slowing growth in the traditional prescription
market. It is e/panding into the provision of health care with the %ake Care clinics in its
stores and plans to e/pand in worksites. It has also e/panded into the specialty pharmacy
sector that focuses on infusion drugs and drugs for infertility, cancer, and 8I:6. 7algreen#s
rivals, 7al*Mart and CI6 Caremark, have taken a different approach that emphasizes
pharmacy benefit managers '>@Ms(. It is unclear at this time which approach will be more
profitable in the ever*changing health care environment. 9ote the similarities and differences
of these strategies with those of the independent pharmacies described under the model of
monopolistic competition in the chapter.
.. a. %rue. If a monopolist is producing where demand is inelastic, marginal revenue is
negative, and total revenue falls as output increases. %his cannot be the profit*ma/imizing
level of output, where marginal revenue e,uals marginal cost. %hat level of output must
occur on the elastic portion of the demand curve.
b. %rue and false. It is true that price is greater than marginal cost at the profit*ma/imizing
level of output for a monopolist. ?owever, marginal revenue is e,ual to marginal cost at this
point. %hus, 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 e/tra units, as
that would reduce profits.
c. "alse. %he firm is already producing the profit*ma/imizing level of output, as marginal
revenue of J); e,uals marginal cost of J);. ?owever, the price of the product 'J<;( is less
than the average variable cost of JA; 'average total cost of J1;; minus average fi/ed cost of
S-42
J1;(. %hus, the firm should shut down because it is not even covering its variable costs of
production.
d. %rue and false. In monopolistic competition, a firm does have some market power because it
produces a differentiated product. ?owever, because there are a large number of firms
producing similar products and there is freedom of entry and e/it '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 e,uals average total cost, although
average total cost is still decreasing.
Chapter 3
Technical Questions
1. a. %he kinked demand curve assumes that other firms will follow price decreases, but not
price increases.
b. 6ee "igure A.1 in the te/t.
c. If marginal costs increase or decrease within the discontinuous range of the marginal revenue
curve, the point at which marginal revenue e,uals marginal cost will remain the same. %hus,
price and output do not change, even though costs 'and profits( are different.
. a. %he dominant strategy for each firm is to price low 'because no matter what the other firm
does, you are better off pricing low(.
b. %he 9ash e,uilibrium is at '1;;, 1;;(. 8t this point, neither firm has an incentive to
change strategy, given what the other firm is doing.
c. %he firms would be collectively better off pricing high, but that is not an e,uilibrium.
S-43
%hey are collectively worse off pricing low, and that is the only e,uilibrium of the game.
$. a. %here is no dominant strategy in this game because no single strategy is better in all cases.
b. %here are two 9ash e,uilibriums, both with the payoffs ';,;(, when either both players
drive on the left or both players drive on the right.
c. %his is a cooperative game because both players benefit from a cooperative solution- there
is no incentive to cheat.
). a. %here is no dominant strategy in this game because no single strategy is better in all cases.
b. %here is no 9ash e,uilibrium in this game. In every case, one player would want to
change strategy, knowing what the other player had chosen.
c. 8ll of the payoffs add up to zero 'or to a constant sum(. 7hatever one player gains, the
other loses, and, thus, there is no way for everyone to win.
.. a. %D 0 1;;; 2 1;P or P 0 1;; 2 1H1;%D- M& 0 1;; 2 1H.%- MC 0 "C 0 1;.
6et M& 0 MC.
1;; 2 1H.% 0 1;
1H.% 0 A;
% 0 ).;
>ut ,uantity into the demand curve e,uation to find price. P 0 J...
>rofit 0 T& 2 TC 0 '..(' ).;( 2 '1;(').;( 0 J),B.; 2 ),.;; 0 J;,.;
b. %he monopolist could set a price of J1. 'or &ust below that(. +ntrants now have no incentive to come
S-44
in, as they will earn zero profits. If P 0 J1. and % 0 <.;, the monopolist#s profit 0 T& 2 TC 0 '1.(
'<.;( 2 '1;('<.;( 0 J1,B.; 2 <,.;; 0 J),.;.
c. %he difference in profit 'per period( is J13,;;;. %he advantages of a limit price depend on how long
entry could be deterred and whether the monopolist e/pects to be able to keep the current cost
advantage.
3. a. If the entrant has already come in, the monopolist gets ; if he prices high and . 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. %he 9ash e,uilibrium is ';, 1;(, where the entrant comes in and the monopolist prices
high.
c. %he 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.
B. a. 6ee "igure A. in the te/t.
b. 6ee "igure A. in the te/t.
c. %he monopolist will have a reduced profit 'you can see this by finding the original and
the new profit areas on the graph(. 8s in ,uestion ., 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.
<. a. %he total marginal cost curve is the horizontal sum of the two marginal costs.
b. 6ee te/t answers for graphs.
S-45
c. If each firm views the cartel price as fi/ed, then M& 'for the firm( > MC3 and each firm
wishes to e/pand output. '!f course, if they do, the price must fall.(
Application Questions
1. In spring ;;A most 5.6. airlines had adopted a strategy of s,ueezing more seats into their
planes. 6ome airlines removed galleys and installed e/tra 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. "or all of the airlines, these changes can mean the
difference between profits and losses for their flights. 6eeD C6eat 6,ueezeD Gow*Cost
Carriers 9ow !ffer the Most Gegroom,E Wall Street !urnal, Fune ), ;;A.
. Uero/ and Oodak traditionally did not directly compete with each other with Uero/ focusing
on office copying and Oodak on film for consumers. @oth companies faced competitive
threats, Uero/ from ink&et printers and Oodak from the development of digital cameras,
which forced them into the same market, digital color printing. @oth companies are located
in 4ochester, 9M, which makes keeping secrets from each other difficult. @oth companies
also face competition from even bigger rivals, ?ewlett*>ackard and Canon. Uero/ and
Oodak are reacting to each other#s strategies by developing a wide range of digital printers,
but both companies face an uncertain future.
$.a. %he ice cream industry does fit the oligopoly model, with two multinationals, 9estle and
5nilever, controlling $) percent of the market. %he behavior of the two companies is
interdependent.
b. %he government influenced this oligopoly behavior by allowing 9estle to purchase :reyer#s
=rand Ice Cream, Inc. %his move increased 9estlV#s market power and its market share to
match those of 5nilever. %he "%C allowed 9estle to keep :reyer#s distribution network, but
S-46
forced it to sell a number of :reyer#s secondary brands. %he move still appears to benefit
9estle.
c. 8lthough 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. %he distribution
network and access to supermarkets are also key components of the firms# competitive
strategies. @oth firms are developing new single*serving products that have higher profit
margins. 9estle is also working to turn more of its candies into ice cream flavors.
). >rocter W =amble and Colgate are focusing on developing new products with different
characteristics to sell more toothpaste to e/isting consumers and to appeal to new groups.
Colgate gained the market advantage with its %otal toothpaste, which promised to fight gum
disease and whiten teeth. >W=#s Crest responded with marketing that emphasized beauty and
taste. %he company used focus groups in a novel way to compare 7hitening +/pressions
with regular Crest. >W= also researched the ?ispanic and 8frican*8merican communities to
determine what toothpaste characteristics would most appeal to these groups. @oth
companies focused on the variety of characteristics that influence consumer demand that we
discussed in Chapter $.
.. "ormal cartel behavior of fi/ing prices and dividing the market is still illegal in most areas.
%he article shows that even though 6tolt and !df&ell appeared to engage in this behavior,
they knew it was illegal and were trying to leave no paper trail behind. %he companies
formalized the process of dividing the market and setting prices and even compared the
benefits of cooperation with all*out war. %ensions developed between the companies, and
there was a danger that the cartel would break down even before antitrust officials entered
S-47
the scene. 6tolt was indicted on charges of price fi/ing and other illegal cartel activities in
6eptember ;;3.
3. %he proposed cartel is likely to fail because the natural gas producers have not been able to
coordinate their behavior in the past. %here are many sources of natural gas around the
world, so alternative supplies would be available even if 4ussia and Iran formed a cartel.
@ecause the 5nited 6tates obtains most of its gas from 9orth 8merica, it would be less
vulnerable to this cartel#s actions. %he motivation for this cartel is similar to that of the
potato farmers# cooperative in Chapter B. >roducers in both areas operate in an e/tremely
competitive market with little control over price. Cooperative behavior is one way to try to
overcome the volatility and uncertainty of a competitive market.
Chapter 14
Technical Questions
1. a. M& 0 P'1 1 1H'2.(( 0 )H.P T ;
b. M& 0 P'1 1 1H'21(( 0 ;
c. M& 0 P'1 1 1H'2;..(( 0 2 P S ;
. a. , 0 21HP1 1 '21.(Q 0 1H1) or BN
b. , 0 21HP1 1 '2<(Q 0 1HB or 1)N
c. , 0 21HP1 1 '2$(Q 0 1H

or .;N
$. a. MC 0 J1;, > 0 J., price elasticity 0 2$.;. %herefore, M4 0 .'1 1 1H'2$(( 0 J13.3B T
J1;. %he price is not optimal, as marginal revenue e/ceeds marginal cost.
b. %he price should be lowered until M4 0 MC.
S-48
). a. % 0 3 2 P or P 0 3 2 %, M& 0 3 2 %, MC 0 "C 0 1
M& 0 MC
3 2 % 0 1
% 0 ..;
P 0 J$..;
X 0 T& 2 TC 0 'J$..;('..;( 2 '1('..;( 0 J<.B. 2 ..; 0 J3..
b. If P 0 MC 0 "C 0 1, % 0 . slices of pizza. %he firm earns nothing on these slices because
price e,uals "C. ?owever, the firm can charge a fi/ed price for this option up to the
ma/imum amount of the consumer surplus at P 0 1. %his is the area of the triangle under
the demand curve and above P 0 1. Consumer surplus is ';..('.('321( 0 ';..('.('.( 0
J1..;. If the firm charges a fi/ed price greater than J3.., but less than J1..;, it will
increase its profit with this two*part pricing strategy.
.. a. % 0 1,;;; 2 .P or P 0 ;; 2 ;.4K, M& 0 ;; 2 ;.)%, MC 0 "C 0 ;. 8t a price of J<;,
the ,uantity demanded is 3;;. 6o consumers buy a total of 3;; units.
b. "irst, calculate the monopoly price. ;; 2 ;.)% 0 ;. % 0 ).;- P 0 J11;- profit 0 'J11; 2
;(').;( 0 J);,.;;. 7ith the block pricing scheme, the monopolist makes 'J1; 2 ;(
');;( on the first );; units and 'J<; 2 ;(';;( on the ne/t ;; units, or J);,;;; plus
J1,;;; for a total of J.,;;;.
3. In the business market, the markup 'over marginal cost( will be 21HP1 1 '2(Q 0 1;;N. In the
vacation market, the markup will be 21HP1 1 '2.(Q 0 .N. %hus, the ratio of weekday to
weekend prices will be 1;;H., or ). 7eekday prices will be four times higher than weekend
prices.
S-49
B. a. %
E
0 A;; 2 P
E
or P
E
0 ).; 2 ;..%
E
M&
E
0 ).; 2 %
E
- MC 0 "C 0 .;
M&
E
0 MC
).; 2 %
E
0 .;
%
E
0 );;- P
E
0 J.;
%
W
0 B;; 2 P
W
or P
W
0 B;; 2 %
W
M&
W
0 B;; 2 %
W
B;; 2 %
W
0 .;
%
W
0 $., P
W
0 J$B.
b. :emand is more elastic in the +ast. %his 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 formulaD e
P
0 PH'P 2 a(. 8t P 0 J);;,
price elasticity in the +ast is );;H');; 2 ).;( 0 );;H2.; 0 2<.;. >rice elasticity in the 7est is
);;H');; 2 B;;( 0 );;H2$;; 0 21.$$$.
<.
Sports Pac/a"e 'ids Pac/a"e
>arents 1; .;
6ports fans .; 1;
=eneralists ); );
7ith the package option of any one package for J.; or the combined bundled package for
S-50
JB;, parents will buy the Oids package, sports fans will buy the 6ports package, and
generalists will buy both. '9ote that generalists will not be willing to buy either package
separately.( %he 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 e/ploits 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. +/amples can be found in current business publications.
. %imken#s strategy changed as a result of the recession in ;;1 and the slow recovery
thereafter, as well as of the increase in imports. More customers also began to demand the
bundled products, so %imken responded in order to maintain their market position. %he
chapter discussion showed how bundling can increase a firm#s revenues if it attracts
customers who would not have purchased the individual components. @undling is also
successful if it reduces the dispersion in willingness to pay. %he case presented additional
factors, such as the change in production methods and the education of customers, necessary
to make bundling a successful strategy. %he case also showed that %imken engaged in
political action as part of its competitive strategy.
$. Ginear %echnology 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 e/penditures(.
Ginear %echnology has operated in a cooperative oligopolistic market where each of the 1
ma&or companies tiptoed around one another#s product lines. ?owever, competition may be
increasing in this market in the future.
S-51
). @oth of these cases are e/amples of versioning, developing specific products to meet the
needs of different customers. In the 7ildeck case, the CliteE version of the product attracted
price*conscious customers who might have purchased from its competitor. ?owever, many
of these customers ended up purchasing the original product, helping 7ildeck maintain its
market share. %he 5nion >acific Cblue streakE service focused on those customers who
wanted faster service and were willing to pay for it. 5nion >acific gained because the new
service did not cost it much more than the regular service.
.. %his is an e/ample of third*degree price discrimination. %he publisher segments the 5.6. and
Indian markets because there is a different willingness to pay in each market. %he publisher
increases its revenues by charging a lower price in the Indian market, which has more elastic
demand. If the publisher charged the high 5.6. price in both markets, it would not be able to
sell in India. If the publisher is going to sell the te/tbook online, it will probably have to set
a single price, typically the high 5.6. price. %his means that it will lose the Indian market.
?owever, if the publisher differentiates the productby, for e/ample, using rupees in the
e/amples in the Indian versionthe two versions of the product can be sold in the two
markets at different prices because they are no longer the same commodity.
3.a.%olls are popular from the viewpoint of road officials because demand appears to be price
inelastic. %here are typically few good substitutes for travel on interstate toll roads. 8s the
toll increases, total revenue to the operating agency increases also.
b. %he impact of maintaining tolls on the 9ew Mork 6tate %hruway is that road*maintenance
costs are borne by %hruway users rather than all ta/payers. %his cross*subsidization policy
can be controversial because users of the toll*free highway benefit, while %hruway users pay
the cost.
S-52
c. "rom the data given, the price elasticity of demand for use of the >ennsylvania %urnpike is
NYK H NY> 0 *1N H )$N 0 *;.;$. %his is very inelastic demand.
Chapter 11
Technical Questions
1. GDP is the market value of all good and services produced in the 5nited 6tates 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 e/port purchases. Investment includes any changes in
inventories that occurred during the year. 6pending on imported goods must be subtracted
from spending
. !f the three choices given, only the purchase of a new house is considered to be investment
when calculating =:>. 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. %he purchase of an automobile for private,
nonbusiness use is treated as consumption spending. %he purchase of corporate bonds
represents the transfer of ownership of e/isting assets.
$. %ransfer 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. %ransfer payments do become part of consumersR income and can influence the
consumption spending category.
). 5.6. =:> measures the total market value of all final goods and services produced in the
economy in one year. Imports are subtracted from e/ports when calculating =:> because
S-53
they do not entail production in the 5nited 6tates.
.. 4eal GDP is the current market value of all newly produced final goods and services in a
given year measured in constant dollars or ad&usted for changes in the price level. 4eal GDP
is nominal current dollar GDP divided by P, a measure of the general level of prices in the
economy. 4eal GDP measures the amount of goods and services produced in a given year,
whether or not the economy is operating at full employment.
3. Calculations are also shown in the table on page )<1 in the te/t.
9ominal =:> and real =:> are the same 'J.;( in the ;;B base year. Case 1 shows an
increase in prices with no increase in ,uantities. 9ominal =:> increase to JA., while real
=:> is constant at J.;. Case shows an increase in ,uantities with no change in prices.
@oth real =:> and nominal =:> increase to JA.. Case $ shows an increase in both prices
and ,uantities. @oth real =:> and nominal =:> increase, although the increase in nominal
=:> is much greater.
TA5&E 116E17 ,ominal )ersus 8eal 9:P
;ear Coffee $cups% #il/ $"allons% 9:P
;;B >rice Kuantity >rice Kuantity
J1.;; 1; J.;; ;
+/penditure J1; J); J.; 'nominal(
J.; 'real(
;;< 'Case 1( >rice Kuantity >rice Kuantity
J1..; 1; J).;; ;
+/penditure J1. J<; JA. 'nominal(
J.; 'real(
;;< 'Case ( >rice Kuantity >rice Kuantity
J1.;; 1. J.;; );
+/penditure J1. J<; JA. 'nominal(
S-54
JA. 'real(
;;< 'Case $( >rice Kuantity >rice Kuantity
J1..; 1. J).;; );
+/penditure J..; J13; J1<..; 'nominal(
JA. 'real(
B. Calculations are shown in the following tableD
Table 1161
,ominal )ersus 8eal 9:P $billions <%
)ariable 2444 2441 2442
9ominal =:> JA,<1B.; J1;,1<.; J1;,)3A.3
>ercent Change $.1B $.$B
4eal =:> JA,<1B.; JA,<A;.B J1;,;)<.<
>ercent Change ;.B3 1.3;
=:> :eflator '>rice changes( 1;; 1;.); 1;).1A
>ercent Change .); 1.B.
Application Questions
1. @y March ;;A the manufacturing sector has suffered a sharp contraction and had cut many
&obs. ?owever, fewer positions had been eliminated than would be e/pected. Many
companies had become so lean over the previous decade that assembly lines were running
with only a small number of highly*trained workers. %hese 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 e,uipment.
6eeD %imothy 8eppel and Fustin Gahart, CGean "actories "ind It ?ard to Cut Fobs +ven in a
6lump,E Wall Street !urnal, March A, ;;A.
.%he changes are shown in the following tableD
)ariable
$billions <% 13*4 13+4 1324 1334 2444
4eal =:> J,.;1.< J$,BB1.A J.,131.B JB,11.. JA,<1B.;
S-55
Consumption J1,.AB.) J,).1.A J$,$B).1 J)BB;.$ J3,B$A.)
'3$.AN( '3..;N( '3...N( '3B.1N( '3<.BN(
Investment J33.3 J)B.1 J3)..$ J<A..1 J1,B$...
'1;.BN( '11.$N( '1..N( '1.3N( '1B.BN(
=overnment JB1..) J1,;1.A J1,11..) J1,.$;.; J1,B1.3
'<.3N( '3.AN( '1.BN( '1..N( '1B..N(
+/ports JA;.3 J131.) J$$.. J.... J1,;A3.$
'$.3( ').$N( '3.$N( 'B.<N( '11.N(
Imports J1;$.$ J1$.) J$1;.A J3;B.1 J1,)B..<
').1N( '..BN( '3.;N( '<..N( '1..;N(
The percentage change in real GDP over each decade is
1A3;21AB; .;.<N
1AB;21A<; $3.<N
1A<;21AA; $B.<N
1AA;2;;; $<.;N
Consumption spending remained roughly constant at appro/imately two*thirds of =:>.
Investment spending was more volatile. 8lthough government spending decreased as a
percent of =:> over the decade, remember that this spending does not include transfer
payments. +/port spending and import spending have become larger percentages of =:>
over the period, signifying the increasing importance of the international economy to the
5nited 6tates. %here was a trade surplus 'e/port spending greater than import spending( only
in 1A<;.
$.
Percent Chan"e in )ariable
)ariable 2444 2441 2442 2443 2444 244 244* 244+ 2442
4eal =:> $.B ;.< 1.3 .. $.3 .A .< .; 1.1
=ross >rivate
:omestic
Investment
..B *B.A *.3 $.3 A.B ..< .1 *..) *3.B
S-56
9onresidential
"i/ed
Investment
<.B *). *A. 1.; ..< B. B.. ).A 1.3
4esidential
"i/ed
Investment
;.< ;.) ).< <.) 1;.; 3.$ *B.1 *1B.A *;.<
%he table shows that nonresidential fi/ed investment had negative rates of change in the
;;1 recession, while residential fi/ed investment maintained small positive growth rates.
%he opposite occurred in the recession of ;;B*;;< illustrating the collapse of the housing
market.
). 8dvance estimates of =:> are fairly reliable. 6tudies have shown that initial estimates of
real =:> successfully indicated the direction of change in =:> appro/imately A< percent of
the time- the direction of change in ma&or =:> components about << percent of the time-
whether =:> was accelerating or decelerating B. percent of the time- and whether =:>
growth was above, near, or below trend <; percent of the time. %he mean revision between
the advance estimate and the latest estimate was only ;.) percentage point over the 1A<$2
;;3 period. 6ee F. 6teven Gandefeld, +ugene >. 6eskin, and @arbara M. "raumeni, C%aking
the >ulse of the +conomyD Measuring =:>,E !urnal !' Ec!n!,ic Pers5ecti(es '6pring,
;;<(D 1A$213- :ennis F. "i/ler and @ruce %. =rimm, C%he 4eliability of the =:> and
=:I +stimates,E Sur(ey !' Current Business << ';;<(D 132$.
.. %he following information can be found in the C>I "re,uently 8sked Kuestions on the
@ureau of Gabor 6tatistics web page.
a. %he C>I is the most widely used measure of inflation in the 5nited 6tates. %he >resident,
Congress, and the "ederal 4eserve use the C>I in developing fiscal and monetary policies.
S-57
b. %he C>I is developed from e/penditure information on what families and individuals actually
bought derived from the Consumer +/penditure 6urvey. More than B,;;; families from
around the country provide information on their spending habits in a series of ,uarterly
interviews. 8nother B,;;; families keep diaries listing everything they buy during a two*
week period.
c. %he ma&or groups within the C>I are food and beverages, housing, apparel, transportation,
medical care, recreation, education and communication, and other goods and services. %hese
groups include user fees, such as water and sewer charges- auto registration fees- tolls- and
sales and e/cise ta/es that directly influence the prices of products. %he C>I does not include
financial investment items such as stocks, bonds, real estate, and life insurance that relate to
saving and not consumption.
d. @G6 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. >rices of
about <;,;;; items are recorded each month based on scientific sampling. :ata on specific
items recorded previously are collected. 9ew products and changes in the ,uality of e/isting
products are noted. %he information is then sent to the @G6, where commodity specialists
review the data.
3. %he following table shows the labor force dataD
%he percent of the population in the labor force has increased from 3; percent in 1A3A to
more than 33 percent in 1AA and later years. %he unemployment rate was very low during
the booming periods of the late 1A3;s and the late 1AA;s. It increased substantially during
the recessions of 1A< and 1AA1. %he C&obless recoveryE from the ;;1 recession is
evidenced by the relatively high unemployment rate in ;;$. %he ;;B figures had not yet
S-58
shown the impact of the slowing economic activity in ;;B and ;;<.
Ci!ilian Ci!ilian
,oninstitutiona
l
&abor Force ,umber ,umber
Population $thousands% Emplo=ed >nemplo=e
d
>nemplo=ment
$thousands% $? of population% $thousands
%
$thousands% 8ate $?%
1A3A 1$),$.. <;,B$) BB,A; ,<$ $..
'3;.1(
1A< 1B,B1 11;,;) AA,.3 1;,3B< A.B
'3).;(
1AA 1A,<;. 1<,1;. 11<,)A A,31$ B..
'33.)(
;;; 1,.BB 1),.<$ 1$3,<A1 .,3A ).;
'3B.1(
;;$ 1,13< 1)3,.1; 1$B,B$3 <,BB) 3.;
;;B
$1,<3B
'33.(
1.$,1)
'33.;(
1)3,;)B B,;B< ).3
B. %he following table shows the recessions since 1A3. from the 9@+4 websiteD
Pea/ Trou"h ,umber of #onths
:ecember, 1A3A 'II( 9ovember, 1AB; 'II( 11
9ovember, 1AB$ 'II( March, 1AB. 'I( 13
Fanuary, 1A<; 'I( Fuly, 1A<; 'III( 3
Fuly, 1A<1 'III( 9ovember, 1A< 'II( 13
Fuly, 1AA; 'III( March, 1AA1 'I( <
March, ;;1 'I( 9ovember, ;;1 'II( <
S-59
:ecember, ;;B 'II(
%he 1AB$*B. recession was the longest, while the 1A<; recession was the shortest. %he
1AB$*B. recession was brought on by the 8rab oil embargo, while the 1A<; recession
resulted from tight monetary policy designed to wring the 1AB;s inflation out of the
economy. %he length of the recession that began in :ecember ;;B is not yet known.
<. %he article should focus either on changes in ta/es and government spending 'fiscal policy(
or on changes in the money supply in order to influence interest rates 'monetary policy(. %he
minutes and press releases issued following meetings of the "ederal !pen Market Committee
contain a clear statement of the goals of price stability, full employment, and ade,uate
economic growth and the "ed#s assessment of future economic conditions.
Chapter 12
Technical Questions
1. Induced e/penditures result from changes in real income. %he consumption function,
the basis for the aggregate e/penditure model, specifies that the primary determinant
of household consumption e/penditure is the level of real income. 7e also assume
that some investment and import e/penditure is induced by changes in income.
8utonomous e/penditures result from all factors other than income. Consumption,
investment, and import e/penditures all have an autonomous component. %hese
components are influenced by factors such as ta/es, consumer confidence, the interest
rate, and the currency e/change rate. =overnment e/penditure is assumed to be
entirely autonomous and a function of government policy. +/port e/penditure is
autonomous because it does not depend on changes in domestic real income. It is
S-60
influenced by income in the rest of the world and the currency e/change rate.
. %he currency e/change rate '&( is defined as the number of units of foreign currency per
dollar. 8s & increases, 5.6. imports become cheaper and e/ports become more e/pensive, so
that import spending increases and e/port spending decreases. %he opposite happens when &
decreases. 5.6. imports become more e/pensive and e/ports become cheaper, so that import
spending decreases and e/port spending increases.
$. %he aggregate e/penditure function shifts as followsD
a. 7hen the real interest rate increases, the aggregate e/penditure function shifts down due to
decreases in interest*sensitive consumption and investment spending.
b. 8 decrease in consumer confidence causes consumption e/penditure to decrease
at every level of income. %his shifts the aggregate e/penditure function down.
c. ?igher ta/es on business profits causes investment e/penditure to decrease at
every level of income. %his shifts the aggregate e/penditure function down.
d. If the economies of many countries in the rest of the world go into recessions,
5.6. e/port spending decreases and the aggregate e/penditure function shifts down.
). a. "alse. %he multiplier measures the change in real income that results from a change in
autonomous e/penditure. %he effect of an initial change in autonomous e/penditure is
multiplied because the e/penditure becomes an additional round of income, of which
households spend a certain amount, depending on the marginal propensity to consume.
%his e/penditure generates subse,uent declining rounds of income, of which households
spend a fraction. %he size of the multiplier depends on the marginal propensities to
S-61
consume, invest, and import.
b. "alse. 8n increase in government e/penditure 'G( represents an in&ection into the circular
flow, or e/pansionary fiscal policy. %his is an increase in autonomous e/penditure that
causes the aggregate e/penditure function to shift up. 8n increase in ta/es 'T( represents a
leakage out of the circular flow and causes a downward shift of the aggregate e/penditure
function.
c. "rom the perspective of the national income accounts, real income always e,uals real
e/penditure, given the definition of the circular flow. 7e can measure economic activity
either by the e/penditureHoutput approach or by the incomeHearnings approach. %his
measurement identity does not mean that the economy is always in e,uilibrium.
+,uilibrium is achieved when the desired aggregate e/penditure &ust e,uals the level of
income and output produced and there are no unplanned inventory changes. If the
economy is in dise,uilibrium and there are unplanned inventory changes, the accounting
identity between income and e/penditure still holds because inventory changes are
counted as investment.
.6 C
;
0 ;;, I
;
0 ;;, G
;
0 1;;, X
;
0 1;;, M
;
0 1;;, T
P
0 ;, c
1
0 ;.<, i
1
0 ;.1, ,
1
0 ;.1.
a. E 0 C
;
1 c
1
'# 2 T( 1 I
;
1 i
1
# 1 G
;
1 X
;
2 M
;
2 ,
1
#
T 0 ;
E 0 C
;
1 I
;
1 G
;
1 X
;
2 M
;
1 'c
1
1 i
1
2 ,
1
(#
E 0 ;; 1 ;; 1 1;; 1 1;; 2 1;; 1 ';.< 1 ;.1 2 ;.1.(#
E 0 .;; 1 ;.B.#
S-62
# 0 .;; 1 ;.B.#
# 2 ;.B.# 0 .;;
;..# 0 .;;
#
E
0 ,;;;
b. 9ew M
;
0 ;;
E 0 ;; 1 ;; 1 1;; 1 1;; 2 ;; 1 ';.< 1 ;.1 2 ;.1.(#
E 0 );; 1 ;.B.#
# 0 );; 1 ;.B.#
;..# 0 );;
#
E
0 1,3;;
Change in # 0 );;, change in M 0 1;;, multiplier 0 )
, 0 1HP1 2 'c
1
1 i
1
2 ,
1
(Q 0 1HP1 2 ';.< 1 ;.1 2 ;.1.(Q 0 1HP1 2 ;.B.(Q 0 1H;.. 0 )
c. E 0 C
;
1 c
1
'# 2 T( 1 I
;
1 i
1
# 1 G
;
1 X
;
2 M
;
2 ,
1
#
T 0 1;;
E 0 C
;
2 c
1
T 1 I
;
1 G
;
1 X
;
2 M
;
1 'c
1
1 i
1
2 ,
1
(#
E 0 ;; 2 <; 1 ;; 1 1;; 1 1;; 2 1;; 1 ';.< 1 ;.1 2 ;.1.(#
E 0 ); 1 ;.B.#
S-63
# 0 ); 1 ;.B.#
;..# 0 );
#
E
0 1,3<;
3. C 0 <;; 1 ;.<'# 2 T
P
(, I 0 ;;, G 0 T
P
0 ;;, X 0 M 0 ;
a. # 0 C 1 I 1 G
# 0 <;; 1 ;.<'# 2 ;;( 1 ;; 1 ;;
# 0 <;; 1 ;.<# 2 13; 1 );;
# 0 1;); 1 ;.<#
;.# 0 1;);
# 0 .,;;
b. G 0 $;;
# 0 1,1); 1 ;.<#
;.# 0 1,1);
# 0 .,B;;
# increased by .;;, while G increased by 1;;, so , 0 ..
, 0 1H'1 2 MPC( 0 1H'1 2 ;.<( 0 1H';.( 0 .
c. # 0 <;; 1 ;.<'# 2 $;;( 1 ;; 1 $;;
# 0 <;; 1 ;.<# 2 ); 1 .;;
# 0 1,;3; 1 ;.<#
S-64
;.# 0 1,;3;
# 0 .,$;;
# increases by 1;;, so the e,uilibrium level of income increases even though =
0 %
>
.
Application Questions
1.a. %he decline in stock market prices represents a decrease in consumer wealth. %his would
cause a downward shift in the aggregate e/penditure function and a lower e,uilibrium level
of income. %hese changes contributed to the ;;B*;;< recession.
b. %a/ rebates would cause an increase in consumption e/penditure. %his fiscal policy change
would cause the aggregate e/penditure function to shift up resulting in a higher e,uilibrium
level of income.
c. %his change in monetary policy on the part of the "ed was designed to stimulate the
economy. Gower interest rates would increase consumption and investment spending, shift
up the aggregate e/penditure function, and create a higher e,uilibrium level of income.
. a. 8 greater sensitivity of interest*related consumption and investment e/penditure to
changes in the interest rate would make the I4+ function flatter and result in a larger amount
of interest*related e/penditure for a given change in the interest rate. %his would result in a
larger change in e,uilibrium income.
b. 8 larger multiplier in the aggregate e/penditure model would result in a higher level of
e,uilibrium income for any given increase in interest*related e/penditure.
S-65
$. %he Consumer Confidence Inde/ can be found at the Conference @oard web site.
:iscussions of new data releases are published in The Wall Street !urnal and other business
publications.
). 8s 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. 4eal =:> typically falls for at
least two ,uarters. %he recession of ;;1 caused a lack of consumer demand for many
businesses, resulting in declining profits and employee layoffs. %he fact that the dollar
remained strong did not provide any relief for businesses producing in the 5nited 6tates and
competing with foreign companies. %he strong dollar decreased the price of 5.6. imports and
increased the price of e/ports. 5.6. 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.
.. In "ebruary ;;< Congress passed a J13< billion economic stimulus bill designed to slow
the decline in economic activity. %a/payers received up to J3;; for individuals or J1,;;
for married couples, amounts that phased out at higher income levels. In "ebruary ;;A
Congress passed a JB<A billion stimulus bill that included J.;B billion in spending programs
and J< billion in ta/ cuts. %he bill contained more than J1.; billion in public works
pro&ects for transportation, energy, and technology and J<B billion to help states meet rising
Medicaid costs. 6eeD C+conomic 6timulus,E The New #!r+ Ti,es, Fune 3, ;;A.
3. %he news article describes the loss of &obs associated with the slowing economy early in
;;<. Check the 7eb page of the @ureau of Gabor 6tatistics 'www.bls.gov( to find data and
analysis of the current employment and unemployment situation.
Chapter 13
S-66
Technical Questions
1.a. Checking account deposits or demand deposits are part of the M1 money supply. %hey are
generally accepted li,uid assets that can easily be used to make transactions and are available
on demand.
b. 6tocks are not part of M1 or of any definition of the money supply. %hey are a type of
financial asset that typically provides a greater rate of return, but cannot be used as a medium
of e/change.
c. 6avings account deposits are part of the M money supply, but not the M1 definition. %hey
are somewhat less li,uid than coin, currency, and demand deposits because they do not have
checking privileges.
d. =overnment bonds are not part of the money supply. Gike stocks, they tend to provide a
greater rate of return, but they cannot be used as a medium of e/change.
. 8 fractional reserve banking system is one in which banks are re,uired to keep only a
fraction of their deposits as reserves in the bank or on deposit with the "ederal 4eserve. %his
system allows them to use the e/cess reserves to make loans, which provide income to the
bank. If these loans are redeposited in the banking system, the overall money supply is
e/panded. %he size of the e/pansion relates to the size of the reserve re,uirement. %he
central bank, or "ederal 4eserve, influences the amount of reserves in the system, which
changes the size of the money supply and prevailing interest rates.
S-67
$. If the reserve re,uirement 'rr( is ;., the simple deposit multiplier, *, is 1Hrr 0 1H;. 0 .. %he
money multiplier, ,,, is '1 1 c(H'c 1 rr 1 e( 0 '1 1 ;.;.(H';.;. 1 ;. 1 ;.1.( 0 1.;. H ;.) 0
.3.. %he 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 e/cess reserve ratio, showing the e/cess reserves that banks hold. @oth of these
factors cause leakages out of the money e/pansion process. ?ouseholds that hold currency
reduce the amount of demand deposits in the system. @anks that hold e/cess reserves reduce
the amount of funds that can be loaned out.
). %he three tools are open market operations, the reserve re,uirement, and the discount rate.
!pen 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. 7ith e/pansionary monetary
policy, the "ederal 4eserve buys securities, which increases the amount of reserves in the
system and drives down the federal funds rates. !ther short*term interest rates follow the
federal funds rate. %his stimulates interest*related consumption and investment e/penditure
and increases real income. !pen market operations are the most fle/ible tool of monetary
policy because they can be used on a daily basis. %he "ed can also change the reserve
re,uirement, regulating how much of their deposits banks must hold as reserves, and the
discount rate, the rate the "ed charges banks to borrow reserves from the "ed. %hese are less*
fle/ible tools that are not changed as fre,uently- they are used more for their announcement
effects than as ma&or tools of monetary policy.
..a. %he "ed sets the discount rate that it charges banks for borrowing reserves.
b. %he "ed does not set the federal funds rate, but it does target this rate through open
S-68
market operations. %he "!MC announces its targeted federal funds rate, but the actual rate is
determined in the competitive market for bank reserves. %he "ed is only one player in this
market.
c. %he prime rate is the rate banks charge their best customers. %his rate is set by
commercial banks, not the "ederal 4eserve.
3. a. %rue. 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. %hey sell bonds to obtain
money, which drives the price of bonds down and the interest rate up. 8s the interest rate
rises, households want to hold less money, and e,uilibrium in the money market is
obtained at a higher interest rate. 7hen money demand e/ceeds money supply,
e,uilibrium is reached only at a higher interest rate.
b. "alse. %he central bank, or the "ederal 4eserve, is the institution that controls the money
supply and influences interest rates in the 5nited 6tates. %he "ederal 4eserve is not part of
the federal government 'Congress and the administration(. It was designed to be insulated
from the political system in this country. %he monetary policy of the "ederal 4eserve is
used more than the fiscal policy of the federal government 'ta/es and e/penditure(
because it is a more fle/ible tool that can better deal with changing economic conditions.
c. "alse. 8 decrease in the reserve re,uirement increases the money supply because banks
have more e/cess reserves to loan out. %hese e/cess reserves create further deposits, a
fraction of which can also be loaned out. If the reserve re,uirement is ;., the simple
deposit multiplier is 1H;. 0 .. If the reserve re,uirement decreases to ;.1, the simple
deposit multiplier becomes 1H;.1 0 1;. %his change results in a greater e/pansion of the
money supply.
S-69
d. "alse. %his statement is closer to a description of the interest*related e/penditure and the
aggregate e/penditure functions in Chapter 1 that show the relationship between the
interest rate and spending on real goods and services. %he real money demand curve
shows the ,uantity of money balances individuals wish to hold at different interest rates.
e. %rueHfalse. 8n increase in the nominal money supply by the "ederal 4eserve shifts the real
money supply curve to the right. %his change results in an increase in the real money
supply. 8n 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. 8ll press releases from the "!MC meetings discuss the targeted federal funds rate
and the balance of risks between the goals of price stability and sustainable economic
growth.
. %he statements that the "!MC 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. %he C>arsing the "edE
feature for the 8pril $;, ;;< "!MC press release noted that the change in the targeted
federal funds rate from .. to .;; percent was the seventh cut since 6eptember ;;B, but it
was Cmodest by recent standards.E %he statement said that the economy Cremains weakE
versus Chas weakened furtherE in the March ;;< statement. %he "ed now identified a
business*spending slowdown in addition to weakening consumer spending and employment
noted previously. %he Csubstantial easing of monetary policy to dateZE language was new.
S-70
=one was the language regarding Cdownside risks to growth remain.E %his language signaled
that the "ed might be ready to suspend its rate*cutting strategy. 6ee C6pring >ause[ >arsing
the "ed,E Wall Street !urnal, 8pril $;, ;;<.
$. %he @eige @ook provides summaries of the economic conditions in all 1 "ederal
4eserve districts.
). %he minutes provide a detailed account of the factors influencing "!MC decisions.
..a If the money demand curve in "igures 1$.. and 1$.3 in the te/t is less sensitive to the interest
rate, it will be steeper than what in shown there. "or any given increase in income
represented by a rightward shift of the money demand curve, e,uilibrium 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. +,uilibrium in the money
market will be at a higher interest rate.
Chapter 14
Technical Questions
1. %he aggregate demand curve shows alternative combinations of the absolute price level
'P( and real income '#( or GDP that result in simultaneous e,uilibrium in both the real
goods and the money markets. 8 decrease in the price level causes an increase in the real
money supply and a decrease in the interest rate to restore e,uilibrium in the money
market. %he lower interest rate causes a higher e,uilibrium level of income in the real
goods market. %hus a lower price level is consistent with a higher e,uilibrium level of
income which is what the aggregate demand curve shows.
S-71
. a. 8n increase in personal ta/es shifts the aggregate e/penditure function down and the
aggregate demand curve to the left.
b. 8n increase in e/pected profits and business confidence shifts the aggregate e/penditure
function up and the aggregate demand curve to the right.
c. 8 decrease in the level of foreign =:> or real income shifts the aggregate e/penditure
function down and the aggregate demand curve to the left.
d. 8 decrease in the nominal money supply by the "ederal 4eserve causes a decrease in the
real money supply, which increases interest rates and lowers interest*related consumption
and investment e/penditure. %his causes a downward shift in the aggregate e/penditure
function and a leftward shift of the aggregate demand curve.
$. 8n increase in the real money supply caused by an increase in the nominal money supply by
the "ederal 4eserve results in a lower interest rate at the same price level. %he lower interest
rate stimulates interest*related e/penditure and results in a higher e,uilibrium level of
income at the same price level. %his 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 e,uilibrium level of income at the lower price level. %his is shown by a
movement along the aggregate demand curve.
). a. "alse. %he short*run aggregate supply curve slopes upward as real income and output
approach the economy#s potential output. %his 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. 8s input costs rise, firms
charge higher prices for their products, and the absolute price level begins to increase.
"irms will produce more real output only as the price level increases.
S-72
b. "alse. %he 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. %rue and false. 8 decrease in the nominal money supply by the "ederal 4eserve, all else
held constant, does shift the aggregate demand '"D( curve left. %his policy change causes
the real money supply to decrease, resulting in a higher interest rate, which decreases
interest*related e/penditure and results in a lower e,uilibrium level of income at the same
price level. 8n increase in the price level, all else held constant, results in an upward
movement along a given "D curve. %he increase in the price level decreases the real
money supply, which results in a higher interest rate and a lower level of real income. %his
results in a movement along a given "D curve, as the nominal money supply is held
constant and there is no change in "ederal 4eserve policy.
d. %rue. %he Oeynesian portion of the short*run aggregate supply 'S"S( curve is the
horizontal portion. %he assumption is that real output can change from increases or
decreases in spending 'aggregate demand( without the price level changing. %his would
be most relevant in a recessionary situation, where there is significant unemployment and
e/cess 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. "alse. 6tagflation occurs when there is an upward shift in the short*run aggregate supply
'S"S( curve resulting from a supply shock, such as an increase in the price of oil. 7ith a
given aggregate demand '"D( curve, the resulting e,uilibrium is at a higher price level
and a lower level of real output. %he economy can both have inflation and be stagnating
at a lower level of real output and employment.
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..a In a closed, mi/ed economy with stable prices, if consumption and investment spending do
not depend on the interest rate, the interest*related e/penditure 'I&E( function is vertical.
%here is no change in consumption and investment spending in response to a change in the
interest rate. %he 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.
3. 7ith an upward sloping S"S curve, an increase in "D from e/pansionary fiscal policy results
in both an increase in real income '#( and an increase in the price level 'P(. %here will be a
smaller increase in real income than if the price level did not rise. %his outcome occurs
because the increase in the price level creates a smaller real money supply, which causes the
interest rate to rise. %his increase in the interest rate chokes off some interest*related
spending, thereby increasing real income by a smaller amount.
Application Questions
1.a 6tagflation is represented by an upward shift of the short*run aggregate supply curve due to
ma&or increases in the costs of production unrelated to demand. %his results in an
Cunwelcome combination of looming recession PstagnationQ and persistent inflation.E
b. %he slump in housing prices decreased consumer wealth, while tighter lending standards
limited consumer#s opportunities to borrow. @oth of these factors caused a decrease in
consumption e/penditure and a leftward shift of the aggregate demand curve. ?igher 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. Garger shifts in this curve mean that the economy can grow faster
without generating inflation. 6ee "igure 1).B in the te/t.
d. If companies can pass higher food and energy costs onto consumers, this is represented by an
upward sloping short*run aggregate supply curve. %his could result in a higher price level
and higher inflation.
e. 8 declining dollar makes 5.6. e/ports less e/pensive and stimulates the 5.6. economy.
?owever, it also causes imports to become more e/pensive and could add to 5.6. inflation.
. "iscal policy changes relate to decisions by the president and Congress on federal
government spending and ta/ation. %he president releases the proposed federal budget every
Fanuary. !ther fiscal policy changes may be proposed, such as the economic stimulus bill in
"ebruary, ;;<. Monetary policy changes typically relate to ongoing decisions by the
"ederal !pen Market Committee and are discussed regularly in all business publications.
$. 4esponses will include relevant policy descriptions from current business publications.
). +conomists continue to debate the size and duration of the productivity increases from the
investment in information technology 'I%( that occurred in the late 1AA;s. %he consensus
appears to be that investments in information technology played a lesser role in productivity
increases after ;;; than they did in the 1AA;s. It is always difficult to measure productivity
changes due to problems in measuring changes in the ,uality of many goods and services. It
can also be difficult to determine whether productivity changes are transitory or more
permanent. 6ee the research of 4obert F. =ordon, 6tephen !liner and :aniel 6ichel, +rik
@ryn&olfsson, :ale Forgenson, and Oevin 6tiroh.
.. %hese forecasts are summarized regularly in the Wall Street !urnal.
Chapter 1
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Technical Questions
16
Table 1627 Effect of :ollar Appreciation and :epreciation on >6S6 E-ports and @mports
R = Euro/$ Domesic Price !an "#$ R = "%&' !an "'$ R = "%(2 Effec on E)*ors
+,- an. /m*ors
+M-
5.6. +/portsD %elevisions J1,;;; +uro B3; +uro <; U decreases
5.6. ImportsD +uropean
Cars
+uro .,;;; J$,A;; J$;,.;; M increases
!an "&$ R ="%&& !an "($ R = "%'(
5.6. +/portsD %elevisions J1,;;; +uro BB; +uro 3<; U increases
5.6. ImportsD +uropean
Cars
+uro .,;;; J$,.;; J$3,<;; M decreases
.a. "alse. 8 trade deficit occurs when import spending e/ceeds e/port spending. %here is a
government budget deficit when the goverment spends more than it receives in ta/
revenue. %he two deficits often move together because government deficit spending
stimulates the economy, which increases import spending.
b. "alse. %he e,uality of planned saving and investment determines e,uilibrium in a closed
'no foreign sector(, private 'no government sector( economy. %his is a balance of leakages
and in&ections in the economy. In an open, mi/ed economy, e,uilibrium occurs when I 1
G 1 X 0 S 1 T 1 M. In this chapter, we rewrote this condition as followsD 'X 2 M( 0 'S 2 I(
1 'T 2 G(. %his condition implies that the trade balance must e,ual the level of private and
public saving in the country.
c. "alse. 8n increase in interest rates in the rest of the world leads to a weaker dollar. 5.6.
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investors supply dollars to the foreign e/change market to purchase euros and yen in order
to make financial investments in those countries with the higher interest rates. %he
increased supply of dollars drives down the value of the dollar in foreign e/change
markets.
d. %rue. 5nder a fi/ed e/change rate policy with global capital flows, a country loses control
of its money supply to maintain that e/change rate. %o fight a devaluation of its currency,
a country#s central bank has to use its foreign e/change reserves to bolster the value of its
currency. %his 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 conse,uences to the economy. 5nder a fle/ible e/change rate system, monetary policy
is typically more effective than fiscal policy in increasing real =:>. +/pansionary
monetary policy increases real income, which increases import spending and lowers the
e/change rate. %his change has a further e/pansionary effect on real spending.
+/pansionary monetary policy also lowers domestic interest rates, which decreases the
demand for domestic currency and lowers the e/change rate. 7hile e/pansionary fiscal
policy stimulates the economy and increases imports, which may lower the e/change 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 1AA;s(, the higher e/change rate
will slow the growth in the economy.
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$. %he "ederal 4eserve will be less likely to raise interest rates in this situation because the
appreciating dollar is already helping to slow the economy down. 8n increase in the
e/change rate increases import spending and reduces e/port spending because imports
become relatively cheaper and e/ports relatively more e/pensive. 9et e/ports decrease and
the economy slows down. %his change means that the "ed does not have to raise interest
rates as significantly in order to restrain the economy.
). If income in the 5nited 6tates grows faster than income in its ma&or trading partners, 5.6.
imports will increase faster than e/ports. 5.6. households and institutions will supply more
dollars to the foreign e/change market to purchase those imports. %he increase in the supply
of dollars will drive the e/change rate down. If the economies of the trading partners begin
to grow faster, that will increase the demand for 5.6. e/ports, which will tend to drive up the
demand for dollars and the currency e/change rate.
.. In the simplified model of %able 1..1, balance of payments e,uilibrium is reached at the
e/change rate where e/port spending e,uals import spending or where the ,uantity
demanded of dollars e,uals the ,uantity supplied in the foreign e/change market. %he
assumption in that model is that the interest rates in the 5nited 6tates and Fapan are e,ual, so
there are no net capital flows. %he more general condition for balance of payments
e,uilibrium is 'X 2 M( 1 '+
i
2 +
!
( 0 ;. Import spending can e/ceed e/port spending, but this
is matched by positive capital inflows '+
i
T +
!
( of the same amount. %he negative balance on
the current account must by matched by a positive balance on the capital account.
3. 8 change in the currency e/change rate '&( causes a movement along the demand curve for
dollars. If & increases, imports become cheaper and e/ports more e/pensive. %here is a
smaller ,uantity of dollars demanded to purchase those e/ports, so the dollar demand curve
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slopes downward. %he level of foreign income and the interest rate differential between the
5nited 6tates and the rest of the world cause the demand curve for dollars to shift. 8n
increase in foreign income creates a greater demand for dollars at every e/change rate and
shifts the demand curve out. If interest rates in the 5nited 6tates are higher than those in the
rest of the world, there are higher capital inflows to the 5nited 6tates, creating an increased
demand for dollars. %he supply of dollars curve slopes upward. 8s the e/change rate
increases, imports become cheaper. 8s import spending increases, the ,uantity of dollars
supplied to the market increases, so there is a larger ,uantity supplied at a higher e/change
rate. %he supply of dollars curve shifts if 5.6. income increases. %his increases import
spending, so more dollars are supplied to the foreign e/change market at every e/change
rate. If interest rates are higher in the rest of the world than in the 5nited 6tates, the supply
of dollars in the foreign e/change market also increases as 5.6. households and institutions
purchase those foreign financial investments. %his also shifts the supply of dollars curve to
the right.
Application Questions
1. 8ll balance of payments statistics can be found on the @ureau of +conomic 8nalysis
international accounts 7eb page 'www.bea.doc.govHbeaHinternational(.
. %he direct foreign investment statistics on the @ureau of +conomic 8nalysis 7eb page can
be broken down by country and area of the world and by industry sector in the 5nited 6tates.
6tudents should find data on how this investment differs by these categories.
$. In Fune ;;A 5.6. %reasury 6ecretary %imothy =eithner urged China to move toward a more
fle/ible e/change*rate regime. Mr. =eithner caused controversy in Fanuary ;;A by
asserting that China was manipulating its currency. ?e later moved away from that
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language. +conomists argued that allowing the yuan to rise would be an important sign that
China was serious about increasing its domestic demand. 6eeD 8ndrew @atson and Maya
Fackson 4andall, C=eithner 5rges 4ole for China in 4ecovery,E Wall Street !urnal, Fune ,
;;A.
). %he value of the euro and the macro policies of the +uropean 5nion countries are discussed
in the Wall Street !urnal and other current business publications.
.. "irms 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, 5.6. policies to influence
the currency e/change rate, and the like.
Chapter 1*
Technical Questions
1. ?igher incomes, increased numbers of automobiles, and the improved road network in China
all stimulated the demand for fast food and influenced Mc:onald#s strategy of developing
drive*through windows in its restaurants. %he company was also influenced by changing
tastes and an evolving social structure in China.
.%he oligopoly model best describes the relationship between Mc:onald#s and O"C in China.
%he two companies have interdependent strategies in terms of restaurant openings, items
included on the menu, and development of drive*throughs. Mc:onald#s is trying to develop
innovative strategies, given that O"C has the larger presence in China. @oth companies have
to decide how much to adapt their menus to local tastes.
$. Me/ico had a large current account deficit that had to be financed by capital inflows from
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abroad. %he government tried to maintain an e/change rate that was too high. 7hen the
capital flows decreased due to higher interest rates in other countries, there was downward
pressure on the e/change rate. Me/ico did not have the reserves to support the e/change rate
and the peso was devalued. Investors also lost confidence in the currency which made the
situation worse.
). 7al*Mart faced challenges in using the same strategies in Me/ico as it did in the 5nited
6tates. 7hen the company opened a supercenter in Monterrey in 1AA$, it was criticized for
charging 1.2; percent more than the 7al*Mart in Garedo, %e/as, two hours by car to the
north. %he company also lacked leverage with Me/ican vendors that gave it an advantage in
the 5nited 6tates. :istribution systems were different in Me/ico, where thousands of
suppliers shipped directly to stores rather than to retailer warehouses. 7al*Mart also faced
ambivalent preferences for 5.6. goods. %he Me/ican news media warned about shoddy
foreign goods, and some consumers were moved by the spirit of Me/ican nationalism to
purchase domestically produced goods. :ifferences in Me/ican lifestyles also meant that the
model of a large store with thousands of products did not immediately transfer to Me/ico.
.. If demand was elastic for Mc:onald#s :ollar Menu items, the percentage change in ,uantity
would be greater than the percentage change in price. %herefore, lowering the price would
increase total revenue. "rom the initial response, it appeared as though the demand was
inelastic. 6ome franchise owners reported that profits were declining from selling the
discount items. 7ith inelastic demand, a decrease in price results in a decrease in total
revenue because the percentage change in ,uantity is less than the percentage change in
price.
3. Mc:onald#s mini*restaurants cost $; percent less to build in 1AA1, but could handle A3
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percent of the volume of a full*sized restaurant. %his is an e/ample of a decision based on
incremental costs and revenues. %he 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.
?owever, this also led to an increase in the number of automobiles and influenced
Mc:onald#s strategy of focusing on developing drive*through windows. China#s economic
stimulus plan in fall ;;< benefited many 5.6. companies from tire and e/cavator makers to
the fast*food chains. 6eeD Fames %. 8reddy and %imothy 8eppel, CChina#s 6timulus 6purs
5.6. @usiness,E Wall Street !urnal, 8pril $;, ;;A. %he ;;< recession increased the
demand for 7al*Mart#s products as more affluent customers began shopping there. %he
company also attempted to gain some of the business available from the demise of Circuit
City 6tores Inc. during the recession. In May ;;A 7al*Mart announced its e/pansion into
India, a market dominated by small retailers. 6eeD Miguel @ustillo, C7al*Mart 6teps 5p Its
=ame in +lectronics 8isle,E Wall Street !urnal, May 1<, ;;A- +ric @ellman, C7al*Mart
+/ports @ig*@o/ Concept to India,E Wall Street !urnal, May <, ;;A.
. Mc:onald#s responded to the changing economic conditions in China that included
increased incomes, urbanization, and use of automobiles. %his led to the development of its
strategy of emphasizing the drive*through as a ma&or engine of growth. %he company had to
develop relationships with Chinese governmental authorities and had to consider how local
customs and preferences affected its menu offerings. 7al*Mart faced similar challenges in
Me/ico, particularly in terms of lifestyle differences and the adaptation of its distribution
strategies to the Me/ican economy. @oth companies faced competition from other multi*
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national corporations and from local firms.
$. %he Chinese government allowed Mc:onald#s to make a deal with China#s largest gas
retailer, state*owned 6inopec =roup, to build drive*throughs at gas stations across the
country. +ntry into China was accomplished through an e,uity &oint venture with the
@ei&ing =eneral Corp. of the 8griculture Industry and Commerce 5nited Co. '@ei&ing#s
:epartment of 8griculture(. %his agreement enabled the company to receive agricultural
subsidies. %he Me/ican government allowed 7al*Mart to move into the banking arena.
%his was in contrast to the opposition the company faced in the 5nited 6tates for the same
strategy.
). Mc:onald#s has focused on changing tastes and preferences by developing more healthy
alternatives on its menus. It developed ?appy Meals and in*store playgrounds to appeal to
children. %he company has tried to improve the ,uality of its service by hiring mystery
shoppers to evaluate service, cleanliness, and food ,uality. Mc:onald#s has developed
different menus and restaurant designs in various countries around the world.
.. 9umerous e/amples can be found in the Wall Street !urnal and other business publications.
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