MICROECO-101 STUDY GUIDE #2- CHAP 4&5

QUESTION: According to By the Numbers, how much would you earn in one year if you worked 2,000 hours (50 weeks × 40 hours) at the federal minimum wage? How much more would you earn per year if you worked at the minimum wage rate in Washington State?

2,000 hours × $7.25 = $14,500. In Washington State: 2,000 hours × $9.19 = $18,380.

QUESTION: Describe cross elasticity of demand. Why do substitutes have positive cross elasticities? Describe income elasticity of demand. What is the difference between normal and inferior goods?

Cross elasticity of demand measures how responsive the quantity demanded of one product is to the price of another product. A positive cross elasticity means that as the price of one product rises, the quantity demanded for the other rises. Thus, for example, if the price of beef rises, the quantity of chicken demanded rises, and beef and chicken are substitutes because chicken is substituted for beef when beef 's price increases. Income elasticity of demand measures how responsive quantity demanded is to consumer income. When consumer income rises, the demand for normal goods rises as well, but falls for inferior goods

QUESTION: According to By the Numbers, rank the types of alternative fuel vehicles in use from the most popular to the least popular.

E85 (ethanol), liquefied petroleum gas, compressed natural gas, electric, liquefied natural gas

QUESTION: Would an excise tax placed on cereal be more likely or less likely to be passed on to consumers than an excise tax on wireless phone and data services? Why or why not?

An excise tax on cereal is less likely to be passed to consumers because cereal is more elastic than wireless phone and data services. In other words, if cereal prices rise, consumers can switch to muffins, bagels, and other breakfast items. If wireless phone and data service prices rise, most individuals are unwilling to give these items up. Therefore, a tax on these services is more likely to be passed on. Note that we are not referring to a specific cereal or a specific wireless company, but to the products in general, in which demand for wireless phones and data services is more inelastic than cereal.

QUESTION: Why would the demand for business airline travel be less elastic than the demand for vacation airline travel by retirees?

Business travelers have less flexibility (they need to solve some problem or make a sale tomorrow) and typically decide to travel with a shorter time horizon than do retirees, who can travel when they can get better prices.

QUESTION: Provide three examples of activities that generate external benefits and three activities that generate external costs.

Many activities generate external benefits, such as getting a flu shot, picking up litter, planting trees, keeping one's yard clean, using public transportation, recycling, acquiring more education, and participating in a class discussion. Many activities generate external costs, such as driving during rush hour, smoking, talking loudly on cell phones, reclining an airline seat, going to work with a contagious illness, and cheating on an exam.

QUESTION: For which of the following pairs of goods or services would the cross elasticity of demand be negative? (a) Uber and Yellow Cab, (b) movie streaming subscriptions and tables, (c) camping tents and camping permits, (d) bowling and co-ed softball, (e) textbook and study guides.

Pairs (b), (c), and (e) would have negative cross elasticities of demand because these pairs of goods are complements to one another.

QUESTION: Over the past decade, many American candy companies, including Hershey Company, Brach's Confections, and Ferrara Pan Candy, opened factories in Mexico and Canada to produce candy that is then shipped back to the United States for sale. Although lower wages in Mexico might explain part of this move, wages in Canada are comparable to U.S. wages. Explain how U.S. price supports (price floors) for the sugar industry may have encouraged these moves.

The U.S. sugar industry is a small but highly protected industry, one in which price supports facilitate U.S. sugar farmers' abilities to earn a comfortable living. However, a consequence of these price supports is that the price of sugar in the United States is much higher than in Mexico and Canada. Because sugar is one of the most important ingredients (inputs) to produce candy, the price support has the effect of shifting the supply curve to the left for U.S.-produced candy, raising its price. By moving production plants to Mexico and Canada, lower-priced sugar can be acquired, allowing the U.S. candy industry to remain competitive against other foreign candy makers.

QUESTION: If the price of chicken rises by 15% and the sales of turkey breasts expand by 10%, what is the cross elasticity of demand for these two products? Are they complements or substitutes?

The cross elasticity of demand is 10%/15% = +0.67, therefore they are substitutes.

QUESTION: Why is the demand for gasoline relatively inelastic, while the demand for Exxon's gasoline is relatively elastic?

The demand for gasoline as a whole is relatively inelastic because there are no close substitutes, gas purchases are a small part of our overall budget, and gas-guzzling cars last a long time. Gasoline, given our current lifestyles, is a necessity. Exxon's gas is just one brand of many, and if Exxon raises its price, many consumers will switch to another brand because gasoline is essentially a commodity (one brand is as good as another).

QUESTION: According to By the Numbers, how much greater is the elasticity of demand for food in Canada than in the United States? How about Mexico compared to the United States?

The elasticity of demand for food in Canada is around 0.21, while in the United States it is around 0.11. Canada's elasticity of demand is greater by 0.1. The elasticity of demand for food in Mexico is around 0.37, or 0.26 higher than in the United States.

QUESTION: Explain why deadweight loss can occur with a price below equilibrium even when some consumers benefit from it.

When a price is below equilibrium, a shortage occurs because suppliers are unwilling to supply all that is demanded at that price. Therefore, consumers who are lucky enough to buy the good at the lower price benefit; however, the reduction in overall output creates a deadweight loss, because some mutually beneficial transactions do not take place unless prices rise toward equilibrium.

CHAP5: QUESTION: When the demand curve is relatively inelastic and the price falls, what happens to total revenue? If the demand is relatively elastic and price rises, what happens to total revenue?

Falls; falls.

QUESTION: Using the graph below, show what happens to consumer surplus when a new technology reduces the cost of production.

When production costs decline, supply increases to S1 in the figure, which increases consumer surplus by the area P1P0ea (the shaded area).

QUESTION: Why does an effective price ceiling appear below the equilibrium rather than above it?

A price ceiling is only effective (binding) when it is low enough so that the market price is restricted. Therefore, in order for a price ceiling to be effective, it must be set below the market equilibrium price.

QUESTION: If a price floor is reduced toward equilibrium but not below it, does the surplus and deadweight loss in this market increase or decrease?

A price floor that is set above the equilibrium price creates a surplus and results in a deadweight loss. As the price floor is reduced, it becomes less restrictive, which means that the surplus of goods falls and the deadweight loss decreases. Once the price floor reaches the equilibrium price, both the surplus and deadweight loss disappear.

QUESTION: Over the past few years, several U.S. states have either legalized recreational marijuana or at least decriminalized its use ("Would Legalizing Marijuana Help the Economy?," Debate.org). Proponents argue that legalizing the use of marijuana would help the economy by boosting economic activity and reducing costs. Do you agree? Why or why not? Use the concepts of supply and demand, and consumer and producer surplus to support your answer.

Although the answer may vary, one of the central economic arguments in favor of legalizing marijuana is that permitting the market to freely operate (even for marijuana) allows consumer and producer surplus to be maximized. When restrictions are placed on a market (in this case, a restriction of no legal sales), any efficiency gains must be achieved in the underground market, where risks are higher. This tends to raise prices that consumers pay, raise costs incurred by producers, and produce no government revenue in terms of taxes. Another argument is that increased supply of legal marijuana will drive down prices, making it less profitable for marijuana traffickers, essentially putting them out of business. But not all people support such policies. Some argue that legalizing marijuana may encourage its use, thereby reducing productivity, among other effects.

QUESTION: . If one automobile brand has an income elasticity of demand of 1.5 and another has an income elasticity equal to −0.3, what would account for the difference? Give an example of a specific brand for each type of car

An income elasticity of demand of 1.5 suggests a luxury brand such as BMW or Mercedes. The car with the income elasticity equal l to −0.3 would be an "inferior good" brand. Any inexpensive car brand may fall into this category.

QUESTION: Describe how consumer surplus and producer surplus are measured.

Consumer surplus is the difference between an individual's willingness-to-pay for a product and the price paid. For a market, consumer surplus is measured as the difference between the demand curve and the price. Producer surplus is the difference between the price of a good and a seller's willingness-to-sell. For a market, producer surplus is measured as the difference between the price and the supply curve.

QUESTION: Describe the impact of time on the price elasticity of supply.

For firms to expand output in response to price changes requires time: time to hire more labor, time to order raw materials, and so on. In the market period, supplies are essentially fixed. In the short run, plant capacity is fixed, but in the long run all factors are variable. The elasticity of supply will be most elastic in the long run, less so in the short run, and least in the market period.

QUESTION: One major rationale for farm price supports is that rapidly improving technology, better crop strains, improved fertilizer, and better farming methods increased supply so significantly that farm incomes were severely depressed. Explain how the elasticity of demand for these crops influences this rationale.

Many farm products tend to have inelastic demands; therefore, a significant increase in supply would push prices down a great deal, causing farming incomes to fall.

QUESTION: The market for organic and locally sourced foods has skyrocketed over the past decade as consumers focus on improving their eating habits. However, severe droughts have caused organic food prices to rise significantly, forcing many consumers to shop at conventional supermarkets (which are increasingly adding organic food options) instead of organic food markets such as Whole Foods. In response, companies such as Whole Foods have begun offering more nonorganic option on their store shelves in order to provide their consumers with more affordable options. Based on this response, what did companies such as Whole Foods realize about the elasticity of demand for organic foods that caused them to lower their prices by changing the type of foods they sell?

Organic food companies realized that organic foods tend to be very elastic because they are easily substituted by non-organic versions sold at lower prices at other grocery stores. Also, organic foods take up a larger share of one's income, and their demand is largely based on personal preferences for healthier foods or animal rights, other reasons why organic foods are elastic. Finally, conventional grocery stores have increased their offerings of organic foods, creating more choices for consumers, which further increases the elasticity of organic foods. Therefore, by offering nonorganic foods, companies like Whole Foods can retain more of their customers who still desire some organic foods but are looking to stay within their budgets by making some substitutions.

QUESTION: Luigi's is the only pizzeria in a small town in northern Alaska. It is constantly busy but there is never a wait for a table. One of Luigi's friends suggests that he would earn much more money if he raises his menu prices by 25%, because no one would likely open a new pizzeria in the near future. If Luigi follows his friend's advice, what would happen to consumer and producer surplus, and efficiency in this market?

Raising the price of pizza might cause some customers to not consume pizza, causing some producer surplus to be lost. But for those customers that continue to buy pizza, producer surplus rises and consumer surplus falls due to the higher price. Efficiency is reduced in this market because fewer pizzas are bought and sold. This outcome is common for businesses with market power (little to no competition) because consumers have few alternatives if prices are raised.

QUESTION: In cities around the country, the government provides assistance to families with low incomes to rent apartments at prices capped by the U.S. Department of Housing and Urban Development (HUD), essentially setting a price ceiling on apartments. These designated apartments tend to rent quickly, and tenants are less likely to move once they find an apartment. Explain how rent controls affect market prices for non-rent-controlled apartments. How are incentives by landlords affected in terms of maintaining rent-controlled and non-rent-controlled apartments? Would your answer change if the government provided a subsidy payment to landlords to offset the difference between the price ceiling and the market price?

Rent controls tend to cause shortages of apartments because more people demand than what is available. Because this may affect the supply of non-rent-controlled apartments, market prices for non-rent-controlled apartments may rise, further widening the difference between the price ceiling and market price. If landlords are not subsidized, they have less incentive to maintain the rent-controlled apartments, especially when non-rent-controlled apartments become more profitable. However, if the government subsidizes rent-controlled apartments (as they do for Section 8 housing approved by HUD), then the rents received by landlords are closer to the market price, reducing the incentives to alter their behavior.

QUESTION: In September 2015 Turing Pharmaceuticals decided to increase the price of the drug Daraprim, which is used to treat a life-threatening parasitic infection. Unlike typical price increases that never make the evening news, Turing raised the price from $13.50 per dose to $750 per dose, representing an increase of over 50 times the price. Turing's CEO Martin Shkreli argued that the extreme price increase was justified based on market demand and the fact that the drug does save lives. How would you describe the elasticity of Daraprim? For practically any other business that chooses to raise its price by 50 times, the business would surely lose most if not all of its customers. Why is Turing still in business? How would the elasticity of Daraprim change if there were generic versions of the drug offered by other companies?

The elasticity of Daraprim is very low, near 0, representing a very inelastic (almost perfectly inelastic) good. This allows Turing Pharmaceuticals to raise its prices substantially without losing many customers. Because many drug patients pay for Daraprim through medical or drug insurance policies, most customers are insensitive to the price changes, in addition to the obvious fact that this is a life-saving drug with very few substitutes. If generic versions of the drug were made available, that would surely increase elasticity as patients (or their insurance providers) search for the lowest-cost alternatives to the drug.

QUESTION: Academic studies suggest that the amount people tip at restaurants is only slightly related to the quality of service, and that tips are poor measures of how happy people are with the service. Is this another example of market failure? What might account for this situation?

To some degree it is probably a form of market failure. If consumers and markets were rational, tips would be based on the quality of service, but they appear not to be. Even returning customers often do not vary their tips (or over-tip) based on service. This fact is probably recognition by customers that people with some jobs are underpaid, and tips are important and fair to bring the salary up. It is also a cultural norm to tip.

QUESTION: The U.S. Department of Labor reports that of the roughly 155 million people employed, just over half are paid hourly, but less than 5% earn the minimum wage or less; 95% of wage earners earn more. And of those earning the minimum wage or less, 25% are teenagers living at home. If so few people are affected by the minimum wage, why does it often seem to be such a contentious political issue?

The minimum wage draws attention probably for several reasons. The first is political: One party—Democratic—is more inclined toward government intervention in the marketplace, and raising the minimum wage is part of its platform. The Republican Party generally favors freer markets, reacts to intervention with skepticism, and focuses on the unemployment caused by increasing the required wage above equilibrium. Second, $7.25 an hour (the U.S. federal minimum wage in 2013) seems unfairly low to many people, and they focus on this unfairness. Third, there is some evidence that increasing the minimum wage increases other wages as well. Thus, unions and others are in favor of increasing the minimum wage because this will enhance their chances of getting wage increases for their members in the future.

QUESTION: According to By the Numbers, which state has the highest average in-state tuition in the country, and which state has the lowest average in-state tuition? How do universities deal with shortages when instate tuition prices are below the equilibrium price?

The state with the highest average in-state tuition is New Hampshire at $14,712 per year (in 2015), and the state with the lowest average in-state tuition is Wyoming at $4,646 per year. Universities deal with shortages by restricting their admissions, usually be setting minimum entrance requirements such as high school grades and SAT or ACT scores. However, because public universities receive subsidies from the state legislature, this, in turn, expands the supply of education, allowing more students to be accommodated. This may be a reason why some of the largest colleges in the nation have very open admission policies. For example, Miami-Dade College is the largest public institution of higher education in the country, with over 160,000 students.

QUESTION: An increasing number of charities have turned to online auctions as a way to raise money by selling unique experiences donated by celebrities (such as a meet-and-greet with a celebrity before a concert or a walk-on role on a television show). Why would the use of auctions lead to a better outcome for the charity as opposed to just setting a fixed price? Explain using the concepts of consumer surplus and producer surplus.

The use of auctions allows the seller to find the buyer with the highest willingness-to-pay, which increases the producer surplus (and reduces the consumer surplus) from the transaction. Although the same outcome can occur with a fixed price, the seller would have to guess correctly what this price would be. If the price is set too low, a buyer with a much higher willingness-to-pay would reap more consumer surplus.

QUESTION: In 2015 Governor Cuomo of New York approved a measure to raise the minimum wage for all fastfood workers to $15 per hour by 2018 ("New York Oks $15 Minimum Wage for Fast-Food Workers," USA Today, September 11, 2015). Proponents argue that this policy helps the working poor who hold full-time jobs yet are not able to pull their families out of poverty. Meanwhile, opponents argue that the policy would cause harm in the labor market. Provide an example of a situation that would support each side's argument.

There are many possible answers based on sound economic arguments. A $15 per hour minimum wage would mean that a person working full time will earn about $30,000 per year, an annual income that is well above the poverty rate for a family of four. Proponents argue that this will reduce poverty and lessen dependence on federal and state income assistance programs (such as food stamps). In turn, government spending would fall, and government revenues would rise because more taxable income is being earned. Also, proponents argue that crime and depression fall when poverty is reduced, providing external benefits to society. Opponents to the minimum wage argue that this policy raises wages above the labor market equilibrium, which would cause employers to hire fewer workers, raising unemployment in the industry. They also argue that the higher wages will result in higher prices as businesses pass on the higher costs to their customers, causing inflation. Some also argue that raising minimum wages in one industry is unfair to workers in other low-pay industries, such as janitors and grocery store workers.

QUESTION: Suppose you estimated the cross elasticities of demand for three pairs of products and came up with the following three values: 2.3, 0.1, −1.7. What could you conclude about these three pairs of products? If you wanted to know if two products from two different firms competed with each other in the marketplace, what would you look for?

When the cross elasticity estimate is 2.3, these products are close substitutes; for 0.1, the products are really unrelated; and a value of −1.7 would represent complements. To find out if the products of two firms compete in the market, we would look for a positive cross elasticity number: the higher the number, the more competitive the products (substitutable).

QUESTION: Consider chip plants: potato and computer. Assume there is a large rise in the demand for computer chips and potato chips. a. How responsive to demand is each in the market period? b. Describe what a manufacturer of each product might do in the short run to increase production. c. How does the long run differ for these products?

a. Neither would be very responsive in the market period. b. Both can hire extra employees, but computer chip manufacturers need to hire and train new employees, and this will take longer for them than for potato chip firms. c. Computer chip factories are extremely expensive to set up (approaching 1 billion dollars) and it takes a long time to obtain permits, build, and make them ready for production. They must locate where a skilled labor force is available and where high-skilled high-tech workers want to live. Potato chip manufacturing is not done on the same scale, and the time needed to increase production is much shorter.

QUESTION: Rising peanut prices have forced peanut butter makers to raise the price of peanut butter from $2 to $3 per jar, causing quantity demanded to fall. In addition, sales of jelly also dropped by 15%. Soon thereafter, makers of chocolate spread dropped its price from $4 to $3 per jar. This resulted in a further decline in peanut butter sales by 20%. a. What is the cross elasticity of demand between peanut butter and jelly (use the midpoint method)? Are these two products complements or substitutes? b. What is the cross elasticity of demand between peanut butter and chocolate spread (use the midpoint method)? Are these two products complements or substitutes?

a. The cross elasticity of demand between peanut butter and jelly is ‒15%/(+$1/$2.50) = ‒ 15%/+40% = ‒0.375. When cross elasticity of demand is negative, the two goods are complements. b. The cross elasticity of demand between peanut butter and chocolate spread is ‒20%/(‒ $1.00/$3.50) = ‒20%/‒28.57% = +0.70. When cross elasticity of demand is positive, the two goods are substitutes.

QUESTION: Suppose the demand and supply for imported Kobe beef is as shown in the figure below. Now assume that the U.S. government imposes a $10 import tax per pound of Kobe beef. ( LOOK AT THE CHART ON CHAP.5 #16) a. How does the market price change with the imposition of the $10 per pound tax? b. Do buyers or sellers of Kobe beef bear the greater burden of the tax? c. How much tax revenue does the government collect from this market? d. Calculate the approximate value of deadweight loss created in this market from the tax

a. The market price rises from $50 to $56 with the $10 tax. b. Buyers bear the greater burden of the tax, because the price rises by $6 while sellers earn $4 less after the tax. c. The government collects $10 per pound times 15,000 pounds = $150,000. d. The deadweight loss is 1/2 × (20,000 − 15,000) × ($56 − $46) = $25,000.