THE COSTS OF PRODUCTION

Transcription

1 13 THE COSTS OF PRODUCTION Problems and Applications 1. a. opportunity cost; b. average total cost; c. fixed cost; d. variable cost; e. total cost; f. marginal cost. 2. a. The opportunity cost of something is what must be given up to acquire it. b. The opportunity cost of running the hardware store is $550,000, consisting of $500,000 to rent the store and buy the stock and a $50,000 opportunity cost, because your aunt would quit her job as an accountant to run the store. Because the total opportunity cost of $550,000 exceeds revenue of $510,000, your aunt should not open the store, as her profit would be negative. 3. a. The following table shows the marginal product of each hour spent fishing: Hours Fish Fixed Cost Variable Cost Total Cost Marginal Product 0 0 $10 $0 $ b. Figure 7 graphs the fisherman's production function. The production function becomes flatter as the number of hours spent fishing increases, illustrating diminishing marginal product. 234

2 Figure 7 c. The table shows the fixed cost, variable cost, and total cost of fishing. Figure 8 shows the fisherman's total-cost curve. It has an upward slope because catching additional fish takes additional time. The curve is convex because there are diminishing returns to fishing time because each additional hour spent fishing yields fewer additional fish. 4. Here is the table of costs: Figure 8 Workers Output Marginal Product Total Cost Average Total Cost Marginal Cost $ $15.00 $ a. See the table for marginal product. Marginal product rises at first, then declines because of diminishing marginal product. b. See the table for total cost. c. See the table for average total cost. Average total cost is U-shaped. When quantity is low, average total cost declines as quantity rises; when quantity is high, average total cost rises as quantity rises. d. See the table for marginal cost. Marginal cost is also U-shaped, but rises steeply as output increases. This is due to diminishing marginal product. e. When marginal product is rising, marginal cost is falling, and vice versa.

3 f. When marginal cost is less than average total cost, average total cost is falling; the cost of the last unit produced pulls the average down. When marginal cost is greater than average total cost, average total cost is rising; the cost of the last unit produced pushes the average up. 5. At an output level of 600 players, total cost is $180,000 (600 $300). The total cost of producing 601 players is $180,901. Therefore, you should not accept the offer of $550, because the marginal cost of the 601st player is $ a. The fixed cost is $300, because fixed cost equals total cost minus variable cost. b. Quantity Total Cost Variable Cost Marginal Cost (using total cost) Marginal Cost (using variable cost) 0 $300 $ $50 $ Marginal cost equals the change in total cost for each additional unit of output. It is also equal to the change in variable cost for each additional unit of output. This occurs because total cost equals the sum of variable cost and fixed cost and fixed cost does not change as the quantity changes. Thus, as quantity increases, the increase in total cost equals the increase in variable cost. 7. a. The fixed cost of setting up the lemonade stand is $200. The variable cost per cup is $0.50. Figure 9

4 b. The following table shows total cost, average total cost, and marginal cost. These are plotted in Figure 9. Quantity (gallons) Total Cost Average Total Cost Marginal Cost 0 $ $208 $ The following table illustrates average fixed cost (AFC), average variable cost (AVC), and average total cost (ATC) for each quantity. The efficient scale is four houses per month, because that minimizes average total cost. Quantity Variable Cost Fixed Cost Total Cost Average Fixed Cost Average Variable Cost Average Total Cost 0 $0 $200 $ $200 $10 $ a. The lump-sum tax causes an increase in fixed cost. Therefore, as Figure 10 shows, only average fixed cost and average total cost will be affected.

5 Figure 10 b. Refer to Figure 11. Average variable cost, average total cost, and marginal cost will all be greater. Average fixed cost will be unaffected. Figure a. The following table shows average variable cost (AVC), average total cost (ATC), and marginal cost (MC) for each quantity. Quantity Variable Cost Total Cost Average Variable Cost Average Total Cost Marginal Cost 0 $0 $ $10 $40 $

6 b. Figure 12 shows the three curves. The marginal-cost curve is below the average-totalcost curve when output is less than four and average total cost is declining. The marginal-cost curve is above the average-total-cost curve when output is above four and average total cost is rising. The marginal-cost curve lies above the average-variable-cost curve. Figure a. The following table shows the firm s fixed cost (FC), variable cost (VC), and total cost (TC): Quantity Fixed Cost Variable Cost Total Cost 0 $100 $0 $

7 b. The following table shows the firm s marginal cost (MC) and average total cost (ATC): Quantity Marginal Cost Average Total Cost $5 $ The marginal-cost and average-total-cost curves are shown in Figure 13. Figure 13 c. The firm s marginal cost is $5 for every unit produced. This implies that the production function does not face diminishing marginal returns. 12. The following table shows quantity (Q), total cost (TC), and average total cost (ATC) for the three firms: Firm A Firm B Firm C Quantity TC ATC TC ATC TC ATC 1 $60 $60 $11 $11 $21 $

8 Firm A has economies of scale because average total cost declines as output increases. Firm B has diseconomies of scale because average total cost rises as output rises. Firm C has economies of scale for output from one to three and diseconomies of scale for levels of output beyond three units.

9 14 FIRMS IN COMPETITIVE MARKETS Problems and Applications 1. a. The rise in the price of crude oil increases production costs for individual firms and thus shifts the industry supply curve up, as shown in Figure 3. The typical firm's initial marginal-cost curve is MC 1 and its average-total-cost curve is ATC 1. In the initial equilibrium, the industry supply curve, S 1, intersects the demand curve at price P 1, which is equal to the minimum average total cost of the typical firm. Thus, the typical firm earns no economic profit. Figure 3 b. The increase in the price of oil shifts the typical firm's cost curves up to MC 2 and ATC 2, and shifts the industry supply curve up to S 2. The equilibrium price rises from P 1 to P 2, but the price does not increase by as much as the increase in marginal cost for the firm. As a result, price is less than average total cost for the firm, so profits are negative. In the long run, the negative profits lead some firms to exit the industry. As they do so, the industry-supply curve shifts to the left. This continues until the price rises to equal the minimum point on the firm's average-total-cost curve. The long-run equilibrium occurs with supply curve S 3, equilibrium price P 3, industry output Q 3, and firm's output q 3. Thus, in the long run, profits are zero again and there are fewer firms in the industry. 2. Once you have ordered the dinner, its cost is sunk, so it does not represent an opportunity cost. As a result, the cost of the dinner should not influence your decision about whether to finish it or not.

10 3. Because Bob s average total cost is $280/10 = $28, which is greater than the price, he will exit the industry in the long run. Because fixed cost is $30, average variable cost is ($280 $30)/10 = $25, which is less than price, so Bob will not shut down in the short run. 4. Here is the table showing costs, revenues, and profits: Quantity Total Marginal Total Marginal Profit Cost Cost Revenue Revenue 0 $8 --- $0 --- $ $1 8 $ a. The firm should produce five or six units to maximize profit. b. Marginal revenue and marginal cost are graphed in Figure 4. The curves cross at a quantity between five and six units, yielding the same answer as in Part (a). Figure 4 c. This industry is competitive because marginal revenue is the same for each quantity. The industry is not in long-run equilibrium, because profit is not equal to zero.

11 5. a. Costs are shown in the following table: Q TFC TVC AFC AVC ATC MC 0 $100 $ $100 $ b. If the price is $50, the firm will minimize its loss by producing 4 units. This would give the firm a loss of $40. If the firm shuts down, it will earn a loss equal to its fixed cost ($100). c. If the firm produces 1 unit, its loss will still be $100. However, because the marginal costs of the second and third unit are lower than the price, the firm could reduce its loss by producing more units. 6. a. Figure 5 shows the typical firm in the industry, with average total cost ATC 1, marginal cost MC 1, and price P 1. b. The new process reduces Hi-Tech s marginal cost to MC 2 and its average total cost to ATC 2, but the price remains at P 1 because other firms cannot use the new process. Thus Hi-Tech earns positive profits. c. When the patent expires and other firms are free to use the technology, all firms average-total-cost curves decline to ATC 2, so the market price falls to P 3 and firms earn zero profit. Figure 5

12 7. Since the firm operates in a perfectly competitive market, its price is equal to its marginal revenue of $10. This means that average revenue is also $10 and 50 units were sold. 8. a. Profit is equal to (P ATC) Q. Therefore, profit is ($10 $8) 100 = $200. b. For firms in perfect competition, marginal revenue and average revenue are equal. Since profit maximization also implies that marginal revenue is equal to marginal cost, marginal cost must be $10. c. Average fixed cost is equal to AFC /Q which is $200/100 = $2. Since average variable cost is equal to average total cost minus average fixed cost, AVC = $8 - $2 = $6. d. Since average total cost is less than marginal cost, average total cost must be rising. Therefore, the efficient scale must occur at an output level less than a. If firms are currently incurring losses, price must be less than average total cost. However, because firms in the industry are currently producing output, price must be greater than average variable cost. If firms are maximizing profits, price must be equal to marginal cost. b. The present situation is depicted in Figure 6. The firm is currently producing q 1 units of output at a price of P 1. Figure 6 c. Figure 6 also shows how the market will adjust in the long run. Because firms are incurring losses, there will be exit in this industry. This means that the market supply curve will shift to the left, increasing the price of the product. As the price rises, the remaining firms will increase quantity supplied. Exit will continue until price is equal to minimum average total cost. Average total cost will be lower in the long run than in the short run. The total quantity supplied in the market will fall.

13 10. a. Figure 7 illustrates the situation in the U.S. textile industry. With no international trade, the market is in long-run equilibrium. Supply intersects demand at quantity Q 1 and price $30, with a typical firm producing output q 1. Figure 7 b. The effect of imports at $25 is that the market supply curve follows the old supply curve up to a price of $25, then becomes horizontal at that price. As a result, demand exceeds domestic supply, so the country imports textiles from other countries. The typical domestic firm now reduces its output from q 1 to q 2, incurring losses, because the large fixed costs imply that average total cost will be much higher than the price. c. In the long run, domestic firms will be unable to compete with foreign firms because their costs are too high. All the domestic firms will exit the industry and other countries will supply enough to satisfy the entire domestic demand. 11. a. The firms' variable cost (VC), total cost (TC), marginal cost (MC), and average total cost (ATC) are shown in the table below: Quantity VC TC MC ATC b. If the price is $10, each firm will produce five units, so there will be = 500 units supplied in the market.

14 c. At a price of $10 and a quantity supplied of five, each firm is earning a positive profit because price is greater than average total cost. Thus, entry will occur and the price will fall. As price falls, quantity demanded will rise and the quantity supplied by each firm will fall. d. Figure 8 shows the long-run industry supply curve, which will be horizontal at minimum average total cost. Figure a. Figure 9 shows the current equilibrium in the market for pretzels. The supply curve, S 1, intersects the demand curve at price P 1. Each stand produces quantity q 1 of pretzels, so the total number of pretzels produced is 1,000 q 1. Stands earn zero profit, because price is equal to average total cost. Figure 19

15 b. If the city government restricts the number of pretzel stands to 800, the industry-supply curve shifts to S 2. The market price rises to P 2, and individual firms produce output q 2. Industry output is now 800 q 2. Now the price exceeds average total cost, so each firm is making a positive profit. Without restrictions on the market, this would induce other firms to enter the market, but they cannot because the government has limited the number of licenses. c. If the city charges a license fee for the licenses, it will have no effect on marginal cost, so it will not affect the firm's output. It will, however, reduce the firm's profits. As long as the firm is left with a zero or positive profit, it will continue to operate. Thus, as long as the industry supply curve is unaffected, the price of pretzels will not change. d. The license fee that brings the most money to the city is equal to (P 2 - ATC 2 ) q 2, which is the amount of each firm's profit. 13. a. Figure 10 illustrates the gold-mining industry and a representative gold mine (firm). The demand curve, D 1, intersects the supply curve at industry quantity Q 1 and price P 1. Because the industry is in long-run equilibrium, the price equals the minimum point on the representative firm's average total cost curve, so the firm produces output q 1 and makes zero profit. b. The increase in jewelry demand leads to an increase in the demand for gold, shifting the demand curve to D 2. In the short run, the price rises to P 2, industry output rises to Q 2, and the representative firm's output rises to q 2. Because price now exceeds average total cost, the representative firm now earns positive profits. c. Because gold mines are earning positive economic profits, over time other firms will enter the industry. This will shift the supply curve to the right, reducing the price below P 2. But it is unlikely that the price will fall all the way back to P 1, because gold is in short supply. Costs for new firms are likely to be higher than for older firms, because they will have to discover new gold sources. So it is likely that the long-run supply curve in the gold industry is upward sloping. That means that the long-run equilibrium price will be higher than it was initially. Figure 10

16 8 roduction 18 THE MARKETS FOR THE FACTORS OF PRODUCTION Problems and Applications 1. a. The law requiring people to eat one apple a day increases the demand for apples. As shown in Figure 2, demand shifts from D 1 to D 2, increasing the price from P 1 to P 2, and increasing quantity from Q 1 to Q 2. Figure 2 b. Because the price of apples increases, the value of marginal product increases for any given quantity of labor. There is no change in the marginal product of labor for any given quantity of labor. However, firms will choose to hire more workers and thus the marginal product of labor at the profit-maximizing level of labor will be lower. c. As Figure 3 shows, the increase in the value of marginal product of labor shifts the demand curve of labor from D 1 to D 2. The equilibrium quantity of labor rises from L 1 to L 2, and the wage rises from w 1 to w 2.

17 Figure 3 2. a. If Congress were to buy personal computers for all U.S. college students, the demand for computers would increase, raising the price of computers and thus increasing the value of marginal product of workers who produce computers. This is shown in Figure 4 as a shift in the demand curve for labor from D 1 to D 2. The result is an increase in the wage from w 1 to w 2 and an increase in the quantity of labor from L 1 to L 2. Figure 4 b. If more college students major in engineering and computer science, the supply of labor in the computer industry rises. This is shown in Figure 5 as a shift in the supply curve from S 1 to S 2. The result is a decrease in the wage from w 1 to w 2 and an increase in the quantity of labor from L 1 to L 2.

18 Figure 5 c. If computer firms build new manufacturing plants, this increases the marginal product of labor and the value of the marginal product of labor for any given quantity of labor. This is shown in Figure 6 as a shift in the demand curve for labor from D 1 to D 2. The result is an increase in the wage from w 1 to w 2 and an increase in the quantity of labor from L 1 to L 2. Figure 6 3. a. The marginal product of labor is equal to the additional output produced by an additional unit of labor. The table below shows the marginal product of labor (MPL) for this firm: Days of Labor Units of Output MPL VMPL

19 b. The value of the marginal product of labor (VMPL) is equal to the price multiplied by the marginal product of labor (MPL). It is also reported in the table. c. The labor demand schedule for the firm is: Wage Quantity of Labor Demanded $ d. The labor demand curve is the same as the value-of-the-marginal-product curve. It is shown in Figure 7. Figure 7 e. If the price of the output rises to $12, the demand for labor will shift to the right because the value of the marginal product will be higher at each level of labor hired. 4. a. Because the firm can sell all of the milk it wants to at the market price of $4 per gallon, Smiling Cow Dairy operates in a perfectly competitive output market. b. Since the firm can rent all the robots it wishes at the market price of $100 per day, Smiling Cow Dairy rents robots in a perfectly competitive market. c. The table below shows the MP and VMP for robots:

20 # Robots Total Output MP VMP 0 0 gallons gallons $ d. The firm should rent robots up to the point where VMP is equal to the wage. Therefore, it should rent 4 robots. 5. Because your uncle is maximizing his profit, he must be hiring workers such that their wage equals the value of their marginal product. Because the wage is $6 per hour, their value of marginal product must be $6 per hour. Because the value of marginal product equals the marginal product times the price of the good and because the price of a sandwich is $3, the marginal product of a worker must be two sandwiches per hour. 6. a. When a freeze destroys part of the Florida orange crop, the supply of oranges declines, so the price of oranges rises. Because there are fewer oranges in a given area of orange trees, the marginal product of orange pickers declines. The value of the marginal product of orange pickers could rise or fall, depending on whether the marginal product falls more or less than the price rises. Thus, you cannot say whether the demand for orange pickers will rise or fall. b. If the price of oranges doubles and the marginal product of orange pickers falls by just 30%, the value of marginal product for a particular quantity of orange pickers increases, shifting the demand for orange pickers to the right, and increasing the equilibrium wage of orange pickers. c. If the price of oranges rises by 30% and the marginal product of orange pickers falls by 50%, the value of marginal product for a particular quantity of orange pickers decreases, shifting the demand for orange pickers to the left, and reducing the equilibrium wage of orange pickers. 7. a. Leadbelly should hire workers up to the point where VMP is equal to the wage of $150 per day. b. Since VMP is equal to $150 at the profit-maximizing level of output, and VMP = MP P, the price of pencils must be $5 per box. c. As Figure 8 shows, the market wage is determined in the labor market ($150 per day). The firm takes this wage as given and chooses its level of labor where VMP is equal to $150 per day.

21 Figure 8 d. The decrease in the supply of labor will raise the equilibrium wage rate (see Figure 9). The increase in wage will reduce the profit-maximizing level of labor hired. The value of marginal product of workers will rise to the level of the new wage. Figure 9 8. a. Figure 10 shows the U.S. capital market when there is an inflow of capital from abroad. The inflow of capital shifts the supply curve to the right, from S 1 to S 2. The result is a reduction in the rental rate on capital from r 1 to r 2 and an increase in the quantity of capital from K 1 to K 2.

22 Figure 10 b. The increase in capital increases the marginal product of labor and the value of marginal product of labor for any given quantity of labor. Figure 11 shows this as a shift in the demand for labor from D 1 to D 2. As a result, the wage rate rises from w 1 to w 2 and the quantity of labor rises from L 1 to L 2. Figure a. If a firm already gives workers fringe benefits valued at more than $3, the new law would have no effect. But a firm that currently has fringe benefits less than $3 would be affected by the law. Imagine a firm that currently pays no fringe benefits at all. The requirement that it pay fringe benefits of $3 reduces the value of marginal product of labor effectively by $3 in terms of the cash wage the firm is willing to pay. This is shown in Figure 12 as a downward shift in the firm's demand for labor from D 1 to D 2, a shift down of exactly $3.

23 Figure 12 b. Because the supply curve has a positive but finite slope, the new equilibrium will be one in which the new wage, w 2, is less than the old wage, w 1, but w 2 > w 1 $3. The quantity of labor also declines. c. The preceding analysis is incomplete, of course, because it ignores the fact that the fringe benefits are valuable to workers. As a result, the supply curve of labor might increase, shown as a shift to the right in the supply of labor in Figure 13. In general, workers would prefer cash to specific benefits, so the mandated fringe benefits are not worth as much as cash would be. But in the case of fringe benefits there are two offsetting advantages: (1) fringe benefits are not taxed; and (2) firms offer cheaper provision of health care than workers could purchase on their own. Thus, whether the fringe benefits are worth more or less than $3 depends on which of these effects dominates. Figure 13

24 Figure 13 is drawn under the assumption that the fringe benefits are worth more than $3 to the workers. In this case, the new wage, w 2, is less than w 1 $3 and the quantity of labor increases from L 1 to L 2. If the shift in the supply curve were the same as the shift in the demand curve, then w 2 = w 1 $3 and the quantity of labor remains unchanged. If the shift in the supply curve were less than the shift in the demand curve, then w 2 > w 1 $3 and the quantity of labor decreases. In all three cases, there is a lower wage and higher quantity of labor than if the supply curve were unchanged. d. Because a minimum-wage law would not allow the wage to decline when greater fringe benefits are mandated, it would lead to increased unemployment, because firms would refuse to pay workers more than the value of their marginal product. 10. a. A union is like a monopoly firm in that it is the only supplier of labor, just as a monopoly is the only supplier of a good or service. b. Just as a monopoly firm wants to maximize profits, a labor union may wish to maximize the labor income of its members. c. Just as the monopoly price exceeds the competitive price in the market for a good, the union wage exceeds the free-market wage in the market for labor. Also, the quantity of output of a monopoly is less than the quantity produced by a competitive industry; this means that employment by a unionized firm will be lower than employment by a nonunionized firm, because the union wage is higher. d. Unions might wish to maximize total labor income of their members, or they might want the highest wage possible, or they might wish to have the greatest employment possible. In addition, they may wish to have improved working conditions, increased fringe benefits, or some input into the decisions made by a firm s management.

25 23 MEASURING A NATION S INCOME Problems and Applications 1. a. Consumption increases because a refrigerator is a good purchased by a household. b. Investment increases because a house is an investment good. c. Consumption increases because a car is a good purchased by a household, but investment decreases because the car in Ford s inventory had been counted as an investment good until it was sold. d. Consumption increases because pizza is a good purchased by a household. e. Government purchases increase because the government spent money to provide a good to the public. f. Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported. g. Investment increases because new structures and equipment were built. 2. With transfer payments, nothing is produced, so there is no contribution to GDP. 3. If GDP included goods that are resold, it would be counting output of that particular year, plus sales of goods produced in a previous year. It would double-count goods that were sold more than once and would count goods in GDP for several years if they were produced in one year and resold in another. 4. a. Nominal GDP for each year is found in the following table: Year Nominal GDP 1 P 1 Q 1 2 P 2 Q 2 3 P 3 Q 3 b. Real GDP for each year is found in the following table: Year Real GDP 1 P 1 Q 1 2 P 1 Q 2 3 P 1 Q 3 c. The GDP deflator for each year is found in the following table: Year GDP deflator (P 2 /P 1 )100 3 (P 3 /P 1 )100 d. Real GDP growth from Year 2 to Year 3 equal to [(Q 3 Q 2 )/Q 2 ] 100 percent.

26 e. The inflation rate as measured by the GDP deflator is [(P 3 P 2 )/P 2 ] 100 percent. 5. a. Calculating nominal GDP: 2008: ($1 per qt. of milk 100 qts. milk) + ($2 per qt. of honey 50 qts. honey) = $ : ($1 per qt. of milk 200 qts. milk) + ($2 per qt. of honey 100 qts. honey) = $ : ($2 per qt. of milk 200 qts. milk) + ($4 per qt. of honey 100 qts. honey) = $800 Calculating real GDP (base year 2008): 2008: ($1 per qt. of milk 100 qts. milk) + ($2 per qt. of honey 50 qts. honey) = $ : ($1 per qt. of milk 200 qts. milk) + ($2 per qt. of honey 100 qts. honey) = $ : ($1 per qt. of milk 200 qts. milk) + ($2 per qt. of honey 100 qts. honey) = $400 Calculating the GDP deflator: 2008: ($200/$200) 100 = : ($400/$400) 100 = : ($800/$400) 100 = 200 b. Calculating the percentage change in nominal GDP: Percentage change in nominal GDP in 2009 = [($400 $200)/$200] 100 = 100%. Percentage change in nominal GDP in 2010 = [($800 $400)/$400] 100 = 100%. Calculating the percentage change in real GDP: Percentage change in real GDP in 2009 = [($400 $200)/$200] 100 = 100%. Percentage change in real GDP in 2010 = [($400 $400)/$400] 100 = 0%. Calculating the percentage change in GDP deflator: Percentage change in the GDP deflator in 2009 = [( )/100] 100 = 0%. Percentage change in the GDP deflator in 2010 = [( )/100] 100 = 100%. Prices did not change from 2008 to Thus, the percentage change in the GDP deflator is zero. Likewise, output levels did not change from 2009 to This means that the percentage change in real GDP is zero. c. Economic well-being rose more in 2008 than in 2009, since real GDP rose in 2009 but not in In 2009, real GDP rose but prices did not. In 2010, real GDP did not rise but prices did. 6. Year Nominal GDP (billions) GDP Deflator (base year: 1996) 2000 $9, $9, a. The growth rate of nominal GDP is ($9,873 $9,269)/$9, % = 6.5%. b. The growth rate of the deflator is ( )/ % = 4.4%. c. Real GDP in 1999 (in 1996 dollars) is $9,269/(113/100) = $8,203.

27 d. Real GDP in 2000 (in 1996 dollars) is $9,873/(118/100) = $8,367. e. The growth rate of real GDP is ($8,367 $8,203)/$8, % = 2.0%. f. The growth rate of nominal GDP is higher than the growth rate of real GDP because of inflation. 7. Many answers are possible. 8. a. GDP is the market value of the final good sold, $180. b. Value added for the farmer: $100. Value added for the miller: $150 $100 = $50. Value added for the baker: $180 $150 = $30. c. Together, the value added for the three producers is $100 + $50 + $30 = $180. This is the value of GDP. 9. In countries like India, people produce and consume a fair amount of food at home that is not included in GDP. So GDP per person in India and the United States will differ by more than their comparative economic well-being. 10. a. The increased labor-force participation of women has increased GDP in the United States, because it means more people are working and production has increased. b. If our measure of well-being included time spent working in the home and taking leisure, it would not rise as much as GDP, because the rise in women's labor-force participation has reduced time spent working in the home and taking leisure. c. Other aspects of well-being that are associated with the rise in women's increased laborforce participation include increased self-esteem and prestige for women in the workforce, especially at managerial levels, but decreased quality time spent with children, whose parents have less time to spend with them. Such aspects would be quite difficult to measure. 11. a. GDP equals the dollar amount Barry collects, which is $400. b. NNP = GDP depreciation = $400 $50 = $350. c. National income = NNP sales taxes = $350 $30 = $320. d. Personal income = national income retained earnings = $320 $100 = $220. e. Disposable personal income = personal income personal income tax = $220 $70 = $150.

28 24 MEASURING THE COST OF LIVING Problems and Applications 1. a. Find the price of each good in each year: Year Cauliflower Broccoli Carrots 2008 $2 $1.50 $ $3 $1.50 $0.20 b. If 2008 is the base year, the market basket used to compute the CPI is 100 heads of cauliflower, 50 bunches of broccoli, and 500 carrots. We must now calculate the cost of the market basket in each year: 2008: (100 x $2) + (50 x $1.50) + (500 x $.10) = $ : (100 x $3) + (50 x $1.50) + (500 x $.20) = $475 Then, using 2008 as the base year, we can compute the CPI in each year: 2008: $325/$325 x 100 = : $475/$325 x 100 = 146 c. We can use the CPI to compute the inflation rate for 2009: ( )/100 x 100% = 46% 2. Many answers are possible. 3. a. The percentage change in the price of tennis balls is (2 2)/2 100% = 0%. The percentage change in the price of golf balls is (6 4)/4 100% = 50%. The percentage change in the price of Gatorade is (2 1)/1 100% = 100%. b. The cost of the market basket in 2009 is ($2 100) + ($4 100) + ($1 200) = $200 + $400 + $200 = $800. The cost of the market basket in 2010 is ($2 100) + ($6 100) + ($2 200) = $200 + $600 + $400 = $1,200. The percentage change in the cost of the market basket from 2009 to 2010 is (1, )/ % = 50%. c. This would lower my estimation of the inflation rate because the value of a bottle of Gatorade is now greater than before. The comparison should be made on a per-ounce basis. d. More flavors enhance consumers well-being. Thus, this would be considered a change in quality and would also lower my estimate of the inflation rate. 4. a. The cost of the market basket in 2009 is (1 $40) + (3 $10) = $40 + $30 = $70.

29 The cost of the market basket in 2010 is (1 $60) + (3 $12) = $60 + $36 = $96. Using 2009 as the base year, we can compute the CPI in each year: 2009: $70/$70 x 100 = : $96/$70 x 100 = We can use the CPI to compute the inflation rate for 2010: ( )/100 x 100% = 37.14% b. Nominal GDP for 2009 = (10 $40) + (30 $10) = $400 + $300 = $700. Nominal GDP for 2010 = (12 $60) + (50 $12) = $720 + $600 = $1,320. Real GDP for 2009 = (10 $40) + (30 $10) = $400 + $300 = $700. Real GDP for 2010 = (12 $40) + (50 $10) = $480 + $500 = $980. The GDP deflator for 2009 = (700/700) 100 = 100. The GDP deflator for 2010 = (1,320/980) 100 = The rate of inflation for 2010 = ( )/ % = 34.69%. c. No, it is not the same. The rate of inflation calculated by the CPI holds the basket of goods and services constant, while the GDP deflator allows it to change. 5. a. Because the increase in cost was considered a quality improvement, there was no increase registered in the CPI. b. The argument in favor of this is that consumers are getting a better good than before, so the price increase equals the improvement in quality. The problem is that the increased cost might exceed the value of the improvement in air quality, so consumers are worse off. In this case, it would be better for the CPI to at least partially reflect the higher cost. 6. a. introduction of new goods; b. unmeasured quality change; c. substitution bias; d. unmeasured quality change; e. substitution bias 7. a. ($0.75 $0.15)/$0.15 x 100% = 400%. b. ($14.32 $3.23)/$3.23 x 100% = 343%. c. In 1970: $0.15/($3.23/60) = 2.8 minutes. In 2000: $0.75/($14.32/60) = 3.1 minutes. d. Workers' purchasing power fell in terms of newspapers. 8. a. If the elderly consume the same market basket as other people, Social Security would provide the elderly with an improvement in their standard of living each year because the CPI overstates inflation and Social Security payments are tied to the CPI. b. Because the elderly consume more health care than younger people do, and because health care costs have risen faster than overall inflation, it is possible that the elderly are worse off. To investigate this, you would need to put together a market basket for the

30 elderly, which would have a higher weight on health care. You would then compare the rise in the cost of the "elderly" basket with that of the general basket for CPI. 9. In deciding how much income to save for retirement, workers should consider the real interest rate, because they care about their purchasing power in the future, not the number of dollars they will have. 10. a. When inflation is higher than was expected, the real interest rate is lower than expected. For example, suppose the market equilibrium has an expected real interest rate of 3% and people expect inflation to be 4%, so the nominal interest rate is 7%. If inflation turns out to be 5%, the real interest rate is 7% minus 5% equals 2%, which is less than the 3% that was expected. b. Because the real interest rate is lower than was expected, the lender loses and the borrower gains. The borrower is repaying the loan with dollars that are worth less than was expected. c. Homeowners in the 1970s who had fixed-rate mortgages from the 1960s benefited from the unexpected inflation, while the banks that made the mortgage loans were harmed.

31 25 PRODUCTION AND GROWTH Problems and Applications 1. The facts that countries import many goods and services yet must produce a large quantity of goods and services themselves to enjoy a high standard of living are reconciled by noting that there are substantial gains from trade. In order to be able to afford to purchase goods from other countries, an economy must generate income. By producing many goods and services, then trading them for goods and services produced in other countries, a nation maximizes its standard of living. 2. a. More investment would lead to faster economic growth in the short run. b. The change would benefit many people in society who would have higher incomes as the result of faster economic growth. However, there might be a transition period in which workers and owners in consumption-good industries would get lower incomes, and workers and owners in investment-good industries would get higher incomes. In addition, some group would have to reduce their spending for some time so that investment could rise. 3. a. Private consumption spending includes buying food and buying clothes; private investment spending includes people buying houses and firms buying computers. Many other examples are possible. Education can be considered as both consumption and investment. b. Government consumption spending includes paying workers to administer government programs; government investment spending includes buying military equipment and building roads. Many other examples are possible. Government spending on health programs is an investment in human capital. This is truer for spending on health programs for the young rather than those for the elderly. 4. The opportunity cost of investing in capital is the loss of consumption that results from redirecting resources toward investment. Over-investment in capital is possible because of diminishing marginal returns. A country can "over-invest" in capital if people would prefer to have higher consumption spending and less future growth. The opportunity cost of investing in human capital is also the loss of consumption that is needed to provide the resources for investment. A country could "over-invest" in human capital if people were too highly educated for the jobs they could get for example, if the best job a Ph.D. in philosophy could find is managing a restaurant. 5. a. When a German firm opens a factory in South Carolina, it represents foreign direct investment.

32 b. The investment increases U.S. GDP because it increases production in the United States. The effect on U.S. GNP would be smaller because the owners would get paid a return on their investment that would be part of German GNP rather than U.S. GNP. 6. a. The United States benefited from the Chinese and Japanese investment because it made our capital stock larger, increasing our economic growth. b. It would have been better for the United States to make the investments itself because then it would have received the returns on the investment itself, instead of the returns going to China and Japan. 7. Greater educational opportunities for women could lead to faster economic growth in these developing countries because increased human capital would increase productivity and there would be external effects from greater knowledge in the country. Second, increased educational opportunities for young women may lower the population growth rate because such opportunities raise the opportunity cost of having a child. 8. a. Individuals with higher incomes have better access to clean water, medical care, and good nutrition. b. Healthier individuals are likely to be more productive. c. Understanding the direction of causation will help policymakers place proper emphasis on the programs that will achieve both greater health and higher incomes. 9. a. Political stability could lead to strong economic growth by making the country attractive to investors. The increased investment would raise economic growth. b. Strong economic growth could lead to political stability because when people have high incomes they tend to be satisfied with the political system and are less likely to overthrow or change the government. 10. a. If output is rising and the number of workers is declining, then output per worker must be rising. b. Policymakers should not be concerned as long as output in the manufacturing sector is not declining. The reduction in manufacturing jobs will allow labor resources to move to other industries, increasing total output in the economy. An increase in productivity of workers (as measured by output per worker) is beneficial to the economy.