ECO 110 Introduction to Economics Professor Mike Rizzo Third COLLECTED Problem Set SOLUTIONS

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1 ECO 110 Introduction to Economics Professor Mike Rizzo Third COLLECTED Problem Set SOLUTIONS This is an assignment that WILL be collected and graded. Once again this assignment is to be completed by your groups. Assigned: Due: Monday, April 3 rd Monday, April 10 th 1. Mankiw, Chapter 4: Problem #8 and Problem # a. Cigars and chewing tobacco are substitutes for cigarettes, since a higher price for cigarettes would increase the demand for cigars and chewing tobacco. b. An increase in the tax on cigarettes leads to increased demand for cigars and chewing tobacco. The result, as shown in Figure 25 for cigars, is a rise in both the equilibrium price and quantity of cigars and chewing tobacco. c. The results in part (b) showed that a tax on cigarettes leads people to substitute cigars and chewing tobacco for cigarettes when the tax on cigarettes rises. To reduce total tobacco usage, policymakers might also want to increase the tax on cigars and chewing tobacco, or pursue some type of public education program. 10. a. If the price of flour falls, since flour is an ingredient in bagels, the supply curve for bagels would shift to the right. The result, shown in Figure 27, would be a fall in the price of bagels and a rise in the equilibrium quantity of bagels.

2 Figure 27 Since cream cheese is a complement to bagels, the fall in the equilibrium price of bagels increases the demand for cream cheese, as shown in Figure 28. The result is a rise in both the equilibrium price and quantity of cream cheese. So, a fall in the price of flour indeed raises both the equilibrium price of cream cheese and the equilibrium quantity of bagels. Figure 28

3 What happens if the price of milk falls? Since milk is an ingredient in cream cheese, the fall in the price of milk leads to an increase in the supply of cream cheese. This leads to a decrease in the price of cream cheese (Figure 29), rather than a rise in the price of cream cheese. So a fall in the price of milk could not have been responsible for the pattern observed. Figure 29 b. In part (a), we found that a fall in the price of flour led to a rise in the price of cream cheese and a rise in the equilibrium quantity of bagels. If the price of flour rose, the opposite would be true; it would lead to a fall in the price of cream cheese and a fall in the equilibrium quantity of bagels. Since the question says the equilibrium price of cream cheese has risen, it could not have been caused by a rise in the price of flour. What happens if the price of milk rises? From part (a), we found that a fall in the price of milk caused a decline in the price of cream cheese, so a rise in the price of milk would cause a rise in the price of cream cheese. Since bagels and cream cheese are complements, the rise in the price of cream cheese would reduce the demand for bagels, as Figure 30 shows. The result is a decline in the equilibrium quantity of bagels. So a rise in the price of milk does cause both a rise in the price of cream cheese and a decline in the equilibrium quantity of bagels.

4 Figure Mankiw, Chapter 5: Quick quiz on p.109; Problem #6, #8 and #10. Quick Quiz: If half of all farm crops are destroyed, then market supply will fall leading to an increase in the price of crops (if the demand for crops is sufficiently inelastic). For those farmers whose crops were not destroyed by droughts, this price increase will allow them to make larger profits. However, it makes little sense to destroy your own crops for two reasons. First, one small farmer is unlikely to have an impact on crop prices, so even if destroying product increased profits, it would not do so my much in this case. Second, by destroying your own crops, if the price for some reason did rise, you have less to sell, and it is not clear that you would make larger profits by selling less at a higher price (it depends on the elasticity of demand for your product). Only if all farmers destroyed their crops together, for example through a government program, would this plan work to make farmers better off. 6. Tom's price elasticity of demand is zero, since he wants the same quantity regardless of the price. Jerry's price elasticity of demand is one, since he spends the same amount on gas, no matter what the price, which means his percentage change in quantity is equal to the percentage change in price. 8. a. With a price elasticity of demand of 0.4, reducing the quantity demanded of cigarettes by 20 percent requires a 50 percent increase in price, since 20/50 = 0.4. With the price of cigarettes currently $2, this would require an increase in the price to $3.33 a pack using the midpoint method (note that ($ $2)/$2.67

5 =.50). b. The policy will have a larger effect five years from now than it does one year from now. The elasticity is larger in the long run, since it may take some time for people to reduce their cigarette usage. The habit of smoking is hard to break in the short run. c. Since teenagers don't have as much income as adults, they are likely to have a higher price elasticity of demand. Also, adults are more likely to be addicted to cigarettes, making it more difficult to reduce their quantity demanded in response to a higher price. 10. a. As Figure 2 shows, in both markets, the increase in supply reduces the equilibrium price and increases the equilibrium quantity. b. In the market for pharmaceutical drugs, with inelastic demand, the increase in supply leads to a relatively large decline in the price and not much of an increase in quantity. Figure 2 c. In the market for computers, with elastic demand, the increase in supply leads to a relatively large increase in quantity and not much of a decline in price.

6 d. In the market for pharmaceutical drugs, since demand is inelastic, the percentage increase in quantity will be less than the percentage decrease in price, so total consumer spending will decline. In contrast, since demand is elastic in the market for computers, the percentage increase in quantity will be greater than the percentage decrease in price, so total consumer spending will increase. 3. Mankiw, Chapter 6: Problems #2, #6, #7 and # a. The imposition of a binding price floor in the cheese market is shown in Figure 3. In the absence of the price floor, the price would be P 1 and the quantity would be Q 1. With the floor set at P f, which is greater than P 1, the quantity demanded is Q 2, while quantity supplied is Q 3, so there is a surplus of cheese in the amount Q 3 Q 2. b. The farmers complaint that their total revenue has declined is correct if demand is elastic. With elastic demand, the percentage decline in quantity would exceed the percentage rise in price, so total revenue would decline. c. If the government purchases all the surplus cheese at the price floor, producers benefit and taxpayers lose. Producers would produce quantity Q 3 of cheese, and their total revenue would increase substantially. But consumers would buy only quantity Q 2 of cheese, so they are in the same position as before. Taxpayers lose because they would be financing the purchase of the surplus cheese through higher taxes.

7 Figure 3 6. If the government imposes a $500 tax on luxury cars, the price paid by consumers will rise less than $500, in general. The burden of any tax is shared by both producers and consumers the price paid by consumers rises and the price received by producers falls, with the difference between the two equal to the amount of the tax. The only exceptions would be if the supply curve were perfectly elastic or the demand curve were perfectly inelastic, in which case consumers would bear the full burden of the tax and the price paid by consumers would rise by exactly $ a. It doesn t matter whether the tax is imposed on producers or consumers the effect will be the same. With no tax, as shown in Figure 6, the demand curve is D 1 and the supply curve is S 1. If the tax is imposed on producers, the supply curve shifts up by the amount of the tax (50 cents) to S 2. Then the equilibrium quantity is Q 2, the price paid by consumers is P 2, and the price received (after taxes are paid) by producers is P 2 50 cents. If the tax is instead imposed on consumers, the demand curve shifts down by the amount of the tax (50 cents) to D 2. The downward shift in the demand curve (when the tax is imposed on consumers) is exactly the same magnitude as the upward shift in the supply curve when the tax is imposed on producers. So again, the equilibrium quantity is Q 2, the price paid by consumers is P 2 (including the tax paid to the government), and the price received by producers is P 2 50 cents. Figure 6 b. The more elastic is the demand curve, the more effective this tax will be in reducing the quantity of gasoline consumed.

8 Greater elasticity of demand means that quantity falls more in response to the rise in the price of gasoline. Figure 7 illustrates this result. Demand curve D 1 represents an elastic demand curve, while demand curve D 2 is more inelastic. To get the same tax wedge between demand and supply requires a greater reduction in quantity with demand curve D 1 than for demand curve D 2. Figure 7 c. The consumers of gasoline are hurt by the tax because they get less gasoline at a higher price. d. Workers in the oil industry are hurt by the tax as well. With a lower quantity of gasoline being produced, some workers may lose their jobs. With a lower price received by producers, wages of workers might decline. 10. a. Programs aimed at making the public aware of the dangers of smoking reduce the demand for cigarettes, shown in Figure 13 as a shift from demand curve D 1 to D 2. The price support program increases the price of tobacco, which is the main ingredient in cigarettes. As a result, the supply of cigarettes shifts to the left, from S 1 to S 2. The effect of both programs is to reduce the quantity of cigarette consumption from Q 1 to Q 2.

9 Figure 13 b. The combined effect of the two programs on the price of cigarettes is ambiguous. The education campaign reduces demand for cigarettes, which tends to reduce the price. The tobacco price supports raise the cost of production of cigarettes, which tends to increase the price. c. The taxation of cigarettes further reduces cigarette consumption, since it increases the price to consumers. As shown in the figure, the quantity falls to Q Mankiw, Chapter 7: Problems #6, #8, #9, #10 6. a. The effect of falling production costs in the market for stereos results in a shift to the right in the supply curve, as shown in Figure 11. As a result, the equilibrium price of stereos declines and the equilibrium quantity increases. b. The decline in the price of stereos increases consumer surplus from area A to A + B + C + D, an increase in the amount B + C + D. Prior to the shift in supply, producer surplus was areas B + E (the area above the supply curve and below the price). After the shift in supply, producer surplus is areas E + F + G. So producer surplus changes by the amount F + G B, which may be positive or negative. The increase in quantity increases producer surplus, while the decline in the price reduces producer surplus. Since consumer surplus rises by B + C + D and producer surplus rises by F + G B, total surplus rises by C + D + F + G. c. If the supply of stereos is very elastic, then the shift of the supply curve benefits consumers most. To take the most dramatic case, suppose the supply curve were horizontal, as

10 shown in Figure 12. Then there is no producer surplus at all. Consumers capture all the benefits of falling production costs, with consumer surplus rising from area A to area A + B. Figure 11 Figure a. The effect of falling production costs in the market for computers results in a shift to the right in the supply curve, as shown in Figure 14. As a result, the equilibrium price of computers declines and the equilibrium quantity increases. The

11 decline in the price of computers increases consumer surplus from area A to A + B + C + D, an increase in the amount B + C + D. Figure 14 Prior to the shift in supply, producer surplus was areas B + E (the area above the supply curve and below the price). After the shift in supply, producer surplus is areas E + F + G. So producer surplus changes by the amount F + G B, which may be positive or negative. The increase in quantity increases producer surplus, while the decline in the price reduces producer surplus. Since consumer surplus rises by B + C + D and producer surplus rises by F + G B, total surplus rises by C + D + F + G.

12 Figure 15 b. Since adding machines are substitutes for computers, the decline in the price of computers means that people substitute computers for adding machines, shifting the demand for adding machines to the left, as shown in Figure 15. The result is a decline in both the equilibrium price and equilibrium quantity of adding machines. Consumer surplus in the adding-machine market changes from area A + B to A + C, a net change of C B. Producer surplus changes from area C + D + E to area E, a net loss of C + D. Adding machine producers are sad about technological advance in computers because their producer surplus declines. c. Since software and computers are complements, the decline in the price and increase in the quantity of computers means that the demand for software increases, shifting the demand for software to the right, as shown in Figure 16. The result is an increase in both the price and quantity of software. Consumer surplus in the software market changes from B + C to A + B, a net change of A C. Producer surplus changes from E to C + D + E, an increase of C + D, so software producers should be happy about the technological progress in computers. d. Yes, this analysis helps explain why Bill Gates is one the world s richest men, since his company produces a lot of software that is a complement with computers and there has been tremendous technological advance in computers.

13 Figure a. Figure 17 illustrates the demand for medical care. If each procedure has a price of $100, quantity demanded will be Q 1 procedures. Figure 17 b. If consumers pay only $20 per procedure, the quantity demanded will be Q 2 procedures. Since the cost to society is $100, the number of procedures performed is too large to maximize total surplus. The quantity that maximizes total surplus is Q 1 procedures, which is less than Q 2. c. The use of medical care is excessive in the sense that

14 consumers get procedures whose value is less than the cost of producing them. As a result, the economy s total surplus is reduced. d. To prevent this excessive use, the consumer must bear the marginal cost of the procedure. But this would require eliminating insurance. Another possibility would be that the insurance company, which pays most of the marginal cost of the procedure ($80, in this case) could decide whether the procedure should be performed. But the insurance company does not get the benefits of the procedure, so its decisions may not reflect the value to the consumer. 10. a. Figure 18 illustrates the effect of the drought. The supply curve shifts to the left, leading to a rise in the equilibrium price from P 1 to P 2 and a decline in the equilibrium quantity from Q 1 to Q 2. Figure 18 b. If the price of water is not allowed to change, there will be a shortage of water, with the shortage shown on the figure as the difference between Q 1 and Q 3. c. The system for allocating water is inefficient because it no longer allocates water to those who value it most highly. Some people who value water at more than its cost of production will be unable to obtain it, so society s total surplus is not maximized.

15 The allocation system seems unfair as well. Water is allocated simply on past usage, rewarding past wastefulness. If a family s demand for water increases, say because of an increase in family size, the policy doesn t allow them to obtain more water. Poor families, who probably used water mostly for necessary uses like drinking, would suffer more than wealthier families who would have to cut back only on luxury uses of water like operating backyard fountains and pools. However, the policy also keeps the price of water lower, which benefits poor families, since otherwise more of their family budget would have to go for water. d. If the city allowed the price of water to rise to its equilibrium price P 2, the allocation would be more efficient. Quantity supplied would equal quantity demanded and there would be no shortage. Total surplus would be maximized. Whether the market allocation would be more or less fair than the proportionate reduction in water under the old policy is difficult to say, but it is likely to be fair. Notice that the quantity supplied would be higher (Q 2 ) in this case than under the water restrictions (Q 3 ), so there is less reduction in water usage. To make the market solution even more fair, the government could provide increased tax relief or welfare payments for poor families who suffer from paying the higher water prices. 5. Suppose the city of Danville decides that it needs to crack down on the consumption of unhealthy foods, so in all of its infinite wisdom, it decides to ban the production and consumption of pizza. Please describe what would happen to the market for pizza after this ban has enacted. Do you think the ban would have its desired impact on health outcomes in Danville? Can you think of any economic actors that would be winners in response to such a policy change? If so, might this suggest to you why this law might have been passed in the first place? First note that making something illegal does not put an end to the supply and demand process. After this law passes, it is likely that the supply of pizza becomes more inelastic (rotates inward) and that demand is relatively unaffected (I would consider answers that claim pizza demand will fall a little bit). This change would end up producing a higher equilibrium price and lower equilibrium quantity of pizza sold. What other market impacts would their be? Well, since it becomes more profitable to make pizza, but it is illegal, we d see a black market in pizza emerging and those that produced the pizza would not only be those that made really good pizza, but also those that are really good at evading the law. Since the quantity of pizza sold

16 would fall a bit, you might think health outcomes would improve. However, two unintended consequences are likely to occur. First, the level of crime is likely to increase, making Danville less healthy (i.e. safe). Second, since the risk of getting caught selling a pizza is higher, producers might begin to make more potent pizza. That is, they might start offering extra cheese as the base ingredient. They might add specialty meats and veggies and cheeses. And, while the number of pizzas consumed might be lower, each pizza that is consumed may well be less healthy than what prevailed before the ban making Danville less healthy than before the law. It is easy to see who the winners would be. Those that have a comparative advantage in crime and those in law enforcement that are able to grant favors or look away in exchange for a kickback of the now illegal businesses. Second, and less malignant, is that non-pizza producers stand to benefit a great deal. Health food stores, supermarkets, Mexican restaurants, etc. all stand to benefit from pizza being banned and as usually happens in the real world these groups might have lobbied the government of Danville for the pizza banning on the grounds of health concerns for the citizens of Danville but the health they really are concerned about is their own bottom lines. 6. The Alfred Dunhill store in London features classic motorcycles, model planes and a humidor, while an Armani store in Milan has video games in the basement. Many high end stores are spending large sums of money sponsoring men s nights by sponsoring pizza, beer and TV nights at their stores. These efforts cost money and reduce the overall amount of foot traffic in a store. So, why do you suppose high-end retailers choose to do this? If the demand for the products in the store is sufficiently inelastic, then Dunhill might want to sell more high priced items but in lower quantities than more lower priced items in higher quantities. By offering these enticements to men, they are likely raising the image of the store, and making it more comfortable for them to spend more money on any one purchase than if they were running through a mall with their spouses and just browsed in the Dunhill store. 7. Based on what you learned about the market process, briefly evaluate the claim by many Marxists that competitive forces corrupt the fairness of resource allocation in a capitalist system. Is what you learned about the nature of market competition consistent with the Marxist doctrine that entrepreneurs are oppressors and consumers and workers are oppressed? Why or why not? I ll leave this as a self-evaluative exercise. This aspect of capitalism is yet another one that is misunderstood by Marxists. Recall that the type of competition espoused by the free-market system is that between demanders

17 themselves and that between suppliers themselves. The essence of a market economy is that buyers compete with buyers to gain the favor of sellers and that sellers compete with sellers to gain the favor of buyers. To understand what is exploitive and unfair, consider the following PS questions. 8. Price controls are meant to prevent money prices from rationing scarce residential space and are often meant to keep the wealthy from obtaining more than the poor. Why do you suppose that most of New York City s rent controlled apartments are occupied by relatively wealthy people? Wealthy people seem to have an advantage in discovering and using the new discriminatory rationing criteria that come unto play when money prices are not allowed to perform the task of allocating scarce goods. Approximately the same people get the goods. But the suppliers of the goods no longer get the same rewards. That s why deterioration sets in soon after rent controls are imposed. Suppose that a person with a very low income who is paying $400 a month for a rent-controlled apartment in Greenwich Village knows that others are willing to pay $2500 to rent that apartment. Don t you think a deal will be made that will put a wealthier person in that unit while making the occupant a lot less poor than he was while living there? 9. Centre College recently completed renovations and additions to its athletic complex, Sutcliffe Hall. In Sutcliffe there is a faculty-staff locker room that contains approximately 50 lockers. It has been observed that well over 100 people use that locker room when they are working out. Initially, all of these lockers were intended to be temporary (i.e. you use them while at the gym and then take everything home with you when you leave). Many people have expressed a desire for permanent lockers. i. Since locker space is a scarce resource, using what you have learned in economics, how would you recommend that Centre College allocate these lockers to the people that want to use them? I d recommend Centre charge a fee or auction off the lockers. ii. An economist here at Centre (yes, an ACTUAL economist) publicly declared that lockers should be allocated via a lottery or by a measure of frequency of use of Sutcliffe Hall. Evaluate these two mechanisms from an economic perspective. While may seem fair, neither of these mechanisms ensure that those people that value locker use the most will have access to the lockers. Even under a frequency requirement, it is not clear that those people that come to the gym

18 every day value lockers more than those that come 3 days a week. What if I bicycle to work every day it becomes far less convenient for me to travel with my gym equipment than for someone that takes a car. Furthermore, there is no reason to believe that a secondary market for lockers will not arise enriching those that were fortunate enough to snag a locker, costing Centre the opportunity to charge for a locker, and ending up costing those that end up with lockers much more than would have been the case under a straight price system. iii. Now, evaluate these two mechanisms from a moral perspective (in other words, is it really true that these methods are more fair than what your proposed solution would be?). Who decides what is fair? What is fair in this case? It is certainly the case that the auction system is far less corruptible than alternative allocation schemes. While these schemes may result in some lucky people who were unable to afford lockers now being able to get them, it is hard to see how this is any more fair than a price mechanism (particularly since a secondary market is likely to emerge). 10.Why do you think that today in the United States the largest denominated bill is $500? The $1,000, $5,000 and $10,000 bills no longer circulate as money. Oops. I think largest bill is now only $100. In any case, smaller denomination bills raise the transactions costs for criminals. Before, perhaps ten million dollars could fit into a briefcase when it was made up of $1,000 notes. With $100 notes, it would now take ten briefcases of money to fulfill a 10 million dollar criminal deal. Not only does this increase transaction costs, but it also increases the chances of getting caught. This is why large denomination bills were abolished. Here are pictures of old US Currency and links to a web page describing them ( ). Wikipedia also has a very good entry on currency at

19 11.Would you be in favor of price-gouging legislation in the aftermath of a natural disaster? Why or why not? Read this article for an example of why it might not make sense to support price gouging legislation:

20 Questions on Are We Scaring Ourselves to Death? 12.How is it that well-intentioned public policies designed to reduce risk often make people LESS safe? Think of the unintended consequences of these policies. For example, air bag requirements lower the cost of driving aggressively and make roads less safe for pedestrians. Think of programs to remove asbestos actually putting more asbestos in the air. Think of all of the money spent to alleviate one type of risk at the expense of other risks. For these next three ques, I ll leave the answers for you to discuss among yourselves. 13.What might explain why the perception that crime is worsening is more widely held than the knowledge that crime has actually remained constant or is falling? In other words, who benefits from these perceptions being widely held? 14.To think about is freedom worth some risk? Should you be allowed to take the risk of riding a bicycle without wearing a helmet? 15.Why would Congress create regulatory agencies that try to reduce risk to an impossible standard of zero? To think about - How come it is so difficult to convince them that they are committing statistical murder? To think about further would you rather the FDA keep potentially lifesaving drugs off the market for years (sometimes decades) or have them brought to market but with the risk that someone might be hurt by them? 16.Explain the difference between positive economics and normative economics. Positive economics is the study of the theory and predictions of the theory of economics. In some sense, it is a study of the conditions and outcomes of the world around us as it currently exists. Normative economics is the analysis of what should be it entails a value judgment and different people could look at the same positive economic model and apply a different normative claim to it. Positive economics is focused on questions of efficiency (the size of the pie) while normative economics is focused on questions of equity and desirability. 17.The magic of economics can be appreciated by the extraordinary degree of social coordination required to allocate scarce resources to competing uses. In a market economy, what is the mechanism that binds each agent together to promote this coordination? How does

21 this mechanism work to ensure that Rizzo gets his coffee at Speedway every morning (in might help you to think about whether the Columbian coffee farmer, or the truck driver, or the coffee wholesaler care about me)? The mechanism is the price system. And it requires no a priori knowledge about people s desires or abilities; it requires no additional steps to incentivize producers and consumers; it requires no central planning board to ensure that social welfare is being maximized.

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