PROBLEM SET #3 Suggested Solutions

Transcription

1 Problem Set #3 Page 1 of 8 PROBLEM SET #3 Suggested Solutions Question #1 is based broadly on a 2007 initiative in SF called Healthy San Francisco, which required all businesses with 20 or more employees to contribute toward health insurance costs of their workers. One description of the program is here Many restaurants in SF started adding an explicit health insurance surcharge to customer bills (2 points total) Monopolistic Competition Mike Lee s Bar (MLB) is a small neighborhood bar operating in a monopolistically competitive industry. MLB distinguishes itself from other bars with its super-friendly bartenders, multiple TVs always tuned to Cal Bears Sports, and amazingly clean bathrooms. a. Initially, Mike Lee s Bar is in long run equilibrium. Draw the graphs that depict this situation at the right, using subscripts 1" to label the curves. Because MLB is in long-run equilibrium in a monopolistically competitive industry, that tells us that MLB is earning zero economic profit at its profit-maximizing quantity, Q 1 where MR = MC. The ATC is just tangent to the demand curve at Q 1 but continues to decline until it hits its minimum as it crosses the MC curve at some quantity Q>Q 1. b. Similar to other bars, Mike Lee s Bar had not been providing health insurance for its employees. The state now enacts a new law: all bars and restaurants must pay for health insurance for their workers. In the short run, what effect will this have on Mike Lee s Bar? Depict the situation in the graph at the right, using subscripts 2" to label the curves and areas. In the space below, explain your graph and note the effects on price, quantity, and MLB profit. Will Mike Lee s customers cover the entire cost of the health insurance in the short run? There are choices to make here, so your graph may look slightly different than this one. The primary choice: is the increase in health insurance costs a fixed cost or a variable cost? Health insurance premiums are not dependent upon how many hours someone works; they are a flat amount per worker. The quantity axis is measuring the quantity of drinks sold in MLB. If you assume that the full range of quantities shown on the graph can be served without changing the number of employees, then the cost of health insurance would be a fixed cost, invariant as the number of drinks changes. In that case, you would show the effect by changing the ATC but not the MC. The effect then would be no immediate change in price or quantity, but short-run losses for Mike Lee s Bar and all other bars in the industry.

2 Problem Set #3 Page 2 of 8 On the other hand, if you assume that as MLB serves more drinks, it needs to hire additional servers, then health insurance premiums are a variable cost. If you were preparing an analysis of this policy for a consultant or a legislative analyst, you would want to be very careful in how you described the change in variable costs. For instance, suppose that MLB hires one additional worker every time the number of drinks served per night increases by 200. That would make for an odd looking MC curve because the health insurance costs would jump when q=200, q=400, q=600, q=800, and so on, but would be the original MC curve in between those jumps. The effect would then be to decrease quantity to just below one of those jump points. Just after Q=Q 2, MC jumps and is greater than MR, so a profit maximizing firm (don t serve the 200 th drink if it requires hiring an additional server), prices would rise, and the firm would incur losses in the short run. So what did we expect to see most of you draw? Assuming the quantity axis is long enough to include quantities that require different numbers of servers, then health insurance premiums would be a variable cost. You can show this with a shift up of the MC and ATC curves. (Again, the nice even increase in MC is not realistic, but it s what you probably drew, which is fine for this problem set. If you are analyzing a similar question for a job, though, you want to get the lumpiness described in the previous paragraph into your analysis). The effect would be a decrease in quantity, increase in price, and short-run losses for MLB. Note that independent of the assumption you made about how to capture the costs of health insurance, the result was losses for the typical bar such as Mike Lee s Bar. c. In the long run, what will be the effect of the new health insurance requirement on neighborhood bars? On the price paid for drinks at neighborhood bars? Explain your answers. There is no need to draw the effect in your graph above doing so can be tricky but do tell us here what you would draw if you were to do so.

3 Problem Set #3 Page 3 of 8 In the long run, some of the neighborhood bars will exit the industry due to the losses. Other firms will wait it out, hoping their competitors go out of business. If MLB is one of the surviving firms, some of the customers of the bars that closed will now start going to Mike Lee s Bar. The demand for drinks at MLB will increase (shift D to the right), which also shifts the MR to the right. The surviving bars will serve more drinks, and the price will rise about P 2. The graph below is messy. We didn t expect you to draw it. d. Now that the bar servers are receiving paid health insurance coverage, they are sick less often and miss fewer days of work. Because they are healthier, they are more productive. They also are less likely to quit their job and leave the bar/restaurant industry because jobs in retail do not provide paid health insurance. How would these effects alter your answers in part c? Explain. The increase in productivity of workers lowers MC. (See Piazza for more discussion). So if having employers cover health insurance premiums (which increases costs) also increases worker productivity (lowering costs), the increase in productivity will offset at least some of the increased cost due to health insurance premiums. If the increase in productivity fully offset the health insurance premiums, then nothing would have changed for MLB from part (a) quantity, price, and profit would all be the same, with increased productivity of workers covering the cost of health insurance premiums. If the increase in productivity partly offset the health insurance premiums (which seems like a more reasonable assumption), then the effects described in (b) and (c) will occur, but to a lesser extent. The increase in prices will not be as great. The number of bars that go out of business will not be as great. The SR drop and LR increase in quantity at the surviving bars will not be as great. 2. (2 points total) Externalities Plenty of news articles on this issue, so I ll just cite a few. On externalities of smoking, On decrease in externalities following a ban on pubic smoking in England, And a good but LONG (134 pp) 1999 article on the Economics of Smoking for the Handbook of Health Economics at fjc.people.uic.edu/presentations/papers/handfinal.pdf Let s look again at the cigarette tax you wrote about in your PS2 essay, this time through the lens of externalities. a. Smoking generates negative externalities. What are two different negative externalities generated by smoking? Plenty of choices. Smell, smoke, asthma attacks, lung disease for children whose parents smoke, health care costs of smokers (borne in part by everyone through health insurance premiums or taxes), lost productivity of workers who smoke because they are sick more often. And on a personal note, the pain of watching a parent unable to breathe because of smoking-related COPD. b. In the top graph at the right, depict the effect of the externality on the market for cigarettes, using subscripts p and s to depict the private and social equilibrium price and quantity. In the bottom graph at the right, show what size of tax could lead smokers to fully internalize the externality, allowing the market to generate the socially optimal quantity of cigarettes smoked. In the area below, tell us how big the tax needs to be in order for smokers to internalize the externality.

4 Problem Set #3 Page 4 of 8 Assuming perfect competition makes sense here. The product sold a pack of Marlboro s is homogeneous; get the pack home and no one will know where you bought it. There are lots of places that sell cigarettes. Becoming a seller of cigarettes is straightforward ( In this question, you needed to choose whether you were approaching this question just in the short run, or in the long run. The difference, remember, is whether there is sufficient time for firms to exit the industry. All textbooks would take just a SR approach to this question, so that is what is shown above. In that case, the tax should be equal to the MDC. The resulting market quantity Q 2 will equal the socially optimal quantity Q s. In this case we say the smokers have internalized the externality. (Even though the tax will be shared by sellers and by smokers, so it would be more accurate to say smokers and those who supply them with cigarettes will internalize the externality. Alternatively you could have approached this question from a long-run perspective. Personally, in this case, I think a LR perspective makes a lot more sense because the adjustment to the long-run in this market is probably very quick. With the exception of tobacco shops not as common in the US as in some countries most of the sellers of cigarettes are places in which cigarettes are just one of many things they sell: 7-11 or gas stations or grocery stores. The long run adjustment in those types of stores will simply involve stopping sales of cigarettes, not completely going out of business.

5 Problem Set #3 Page 5 of 8 In the long run, there is a second shift of the supply curve due to the exit of firms that had been selling cigarettes. In that case, if the tax = MDC, then the long-run quantity Q 3 will be too small, Q 3 < Q S. Assuming the long run adjustment happens quickly, then, means the tax should be less than the MDC as shown below. c. When a tax is implemented in the presence of a negative externality, the tax revenue should be used to offset the costs the externality generates. Looking at your list in part (a) above, where would you say the tax revenue should be used? Go back to and determine whether the proposed initiative will direct tax revenue toward the uses you listed. Based on the list I offered in (a), the revenue would be used to: lower number of smokers (Smell, smoke), cover health care costs ( asthma attacks, lung disease for children whose parents smoke), cover health insurance or tax-funded health care costs (health care costs of smokers).

6 Problem Set #3 Page 6 of 8 According to the website, revenue from the $2.00 tax levied by Proposition 56 would be distributed through a four-step process: Step 1: use new revenue to replace old revenue lost due to lower tobacco consumption resulting from tobacco tax increase. Step 2: use next five percent of revenue to pay the costs of administering the tax. Step 3: allocate $48 million to enforcing tobacco laws, $40 million to physician training to increase the number of primary care and emergency physicians in the state, $30 million towards preventing and treating dental diseases, and $400 thousand to the California State Auditor to audit funds from the new tax. Step 4: allocate 82 percent of remaining funds towards services related to Medi-Cal, 11 percent of remaining funds towards tobacco-use prevention, 5 percent of remaining funds towards research into cancer, heart and lung diseases, and other tobaccorelated diseases, and 2 percent of remaining funds towards school programs focusing on tobacco-use prevention and reduction. You then needed to figure out whether those four steps aligned with your list of the external costs of smoking. d. In your PS2 essay, did you recommend that Prop 56 be passed or defeated? In light of the analysis in this question, what is your recommendation? Discuss (briefly!). Answers will vary. The idea here is that your first analysis of Prop 56 was based on one concept (burden of a tax), but this analysis now also incorporates two additional concepts (long-run adjustment and externalities). Does the new knowledge gained in Econ 1 change your vote on Prop 56? If what you are learning in Econ 1 does affect your vote on Prop 56, here s another bigger question to ponder with your friends: how much knowledge are we assuming voters need in order to cast an informed vote on ballot propositions? Is it reasonable to assume the vast majority of voters have that level of knowledge? There are big questions there, worth pondering in this election year. 3. (3 points total) Macroeconomic Indicators a. Unemployment data are provided by the Bureau of Labor Statistics. Go to On the right under latest numbers, click on Unemployment Rate. You now should be at Click on Table A-1. What was the seasonally adjusted unemployment rate in September 2016? How does this compare with the August 2016 seasonally adjusted unemployment rate? How does it compare with the Sept unemployment rate? The seasonally adjusted unemployment rate in September 2016 was 5.0%. This is 0.1 percentage points higher than the rate in August (Rounding matters. Extended to more digits, the unemployment rate was 4.96% in September and 4.92% in August.) In September 2015 the unemployment rate was 5.1 percent (5.05%, extended to one more digit). So the unemployment rate has been steady for a year.

7 Problem Set #3 Page 7 of 8 b. Now look at Tables A-1 through A-7. Which groups have relatively high and which have relatively low unemployment rates? List group description & unemployment rate in relevant column Relatively high unemployment rate A-1, Teens 16-19, (15.8%) A-2, white teens (14.2%), Black men 20+ (8.2%), black women (7.0%), black teens (27.2%) A-3, Hispanic men 20+ (5.4%), Hispanic women 20+ (6.4%), Hispanic teens (18.5%) A-4, Less than HS diploma (8.5%), A-5, Veterans from non-war periods (7.4%) A-6, Men with a disability (8.9%), Women with a disability (10.8%), A-7, Foreign born women 16+ (5.6%) Relatively low unemployment rate A-1, Men 20+ (4.7%), Women 20+ (4.4%) A-2, White men 20+ (4.1%), White women 20+ (3.8%), Asian (3.9%) A-4, Some college (4.2%), BA or higher (2.5%) A-5, Veterans (3.9%), Gulf War II vets (2.3%), Gulf War I vets (4.0%), WWII, Korea, Vietnam vets (0.7%) A-6, Men with no disability (4.6%), Women with no disability (4.7%), People 65+ with a disability (4.0%), People 65+ with no disability (3.7%) A-7, Foreign born men 16+ (3.4%), native born women 16+ (4.7%) c. Now we re going to use Fred (google fred fed ). In Fred, search civilian unemployment rate. You should see a graph of the U.S. civilian unemployment rate, to If you don t immediately see a graph, try a different browser. Print out and attach a graph that shows the unemployment rate for to Write a paragraph that describes the pattern of unemployment in the United States over the last 16 years. Unemployment increased during the 2001 recession from a low of about 4 percent and continued rising after the official end of the recession, peaking at just over 6 percent in Unemployment gradually declined to about 4.5 percent in During the Great Recession of , the unemployment rate shot up from under 5 percent to nearly 10 percent, peaking in late The unemployment rate has gradually declined since then, and has been about 5 percent for the last year.

8 Problem Set #3 Page 8 of 8 d. Now go to and search unemployment, total and choose the first option (modeled ILO estimate). On the right hand side of the screen, click on the red bar labeled DataBank. Now choose three countries to display in one chart: You ll do this by selecting add country under the word preview. One must be the U.S. The other two are your choice. After you ve chosen your three countries, click chart (above preview). Download and print out the graph you ve created. You could choose any three countries so long as one of them was the U.S. In this graph, you see unemployment for the U.S., Spain, and India. (Sorry about the quality of the jpg.) How did the US pattern of unemployment compare with the patterns of the other two countries you chose? Unemployment rose in the US during the Great Recession but has since declined. In contrast, India shows no rise in unemployment at all over the period. And Spain s unemployment rate started rising at the same time as the US but continued rising even as the US economy entered recovery. e. Go to Click on Gross Domestic Product (GDP) under National. Click on Current-dollar and "real" GDP (Excel) and download the data into excel or google sheets or equivalent. Nominal GDP is current dollars and Real GDP is chained 2009 dollars. Look at the quarterly data for Real GDP (GDP in billions of chained 2009 dollars) peaked in 2007q4 (Oct-Nov-Dec 2007) at $14,991.8 billions of chained 2009 dollars. Nominal GDP (GDP in billions of current dollars) peaked somewhat later, in 2008q3 (July-Aug-Sept 2008) at $14,843.0 billions of chained 2009 dollars. Real GDP hit its trough 2009q2 (Apr-May-Jun 2009) at $14,355.6 billions of chained 2009 dollars. Real GDP passed its previous peak in 2011q3 at $15,021.1 billions of chained 2009 dollars. The recession began in 2007q4; the recovery began in 2009q3.

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10 Problem Set #3 Page 10 of 8 4. (3 points total) Businesses and Employment This essay requires that you go to a business and interview someone about their hiring practices. So that we don t have 660 people wandering into Telegraph Avenue businesses individually, you can do the interview and write the essay in pairs. On bcourses, the PS3 essay assignment has this is a group assignment activated. Because you and your partner may be in different sections that meet on different days, the upload is due for everyone at the same time: Tuesday October 25 at 5:59 pm. Remember to attach a hard copy of your essay to your problem set. Everyone needs to attach a hard copy. You need to go to any business in the area (or, if you are home for the weekend, at home) and talk with the person in charge of hiring. It will probably be easiest if you choose a small business rather than something like Genentech. If you work off-campus for a business, you can just talk with your boss if you like. If you work on-campus (W-2 from UC), your place of work doesn t satisfy the assignment; you work for a government agency, not a business. You also should not choose a non-profit organization. While you are there, take a photo of the business that you can embed in your essay. Ask the person in charge of hiring: What would make you want to hire another person and increase the number of people working here? Be sure they understand you are talking about increasing their work force, not just cutting everyone s hours because another person is hired on. If he or she doesn t have a ready answer, you may want to offer some options: Would you increase the size of your work force if there were more applicants for jobs at your firm? What if you could pay the person a lower wage than you re paying everyone else? What if the employer taxes were lower? What if there were more customers / higher sales? What if there were fewer government regulations? Then write a paper in which you answer these questions: What business did you visit? Embed a photo in your essay. What do they sell? Who are their customers? What was the name and position of the person you talked with? What was the answer to the question: What would make you want to hire another person and increase the number of people working here? Suppose all employers in the economy gave the same answer you received to the question in the previous bullet. In that case, will an increase in aggregate demand cause aggregate employment to increase? Discuss. Of course, there are lots of specific examples, so we can t provide you with this is what you should have written. Guidelines: a. Did you follow the specifications? If so, you remained eligible for full credit. If not, you lost a point right off the top. b. Did you answer the questions asked? If so, you remained eligible for full credit. If not, you probably got partial credit. What did we expect you to learn? Lessons will vary individual by individual, so what s important here is going to be what we learned in the aggregate. Watch for a clicker question based on your interviews!