Chapter 2 - Seneca Valley School District / Overvie · Web viewChapter 02 - The Market System and the Circular Flow 1 26 1 Chapter 2 ANSWERS TO END-OF-CHAPTER AND APPENDIX QUESTIONS

Chapter 02 - The Market System and the Circular Flow

Chapter 2ANSWERS TO END-OF-CHAPTER AND APPENDIX QUESTIONS1-1 What is an opportunity cost? How does the idea relate to the definition of economics? Which of

the following decisions would entail the greatest opportunity cost: Allocating a square block in the heart of New York City for a surface parking lot or allocating a square block at the edge of a typical suburb for such a lot? Explain.An opportunity cost is what was sacrificed to do or acquire something else. The condition of scarcity creates opportunity cost. If there was no scarcity, there would be no need to sacrifice one thing to acquire another. The opportunity cost would be much higher in New York City as the alternative uses for that square block are much more valuable than for a typical suburban city block.

1-2 What is meant by the term “utility” and how does it relate to purposeful behavior?“Utility” refers to the pleasure, happiness, or satisfaction gained from engaging in an activity (eating a meal, attending a ball game, etc.). It is an important component of purposeful behavior because people will allocate their scarce time, energy, and money in an attempt to gain the most utility possible.

1-3 (Key Question) Cite three examples of recent decisions that you made in which you, at least implicitly, weighed marginal costs and marginal benefits.Student answers will vary, but may include the decision to come to class, to skip breakfast to get a few extra minutes of sleep, to attend college, or to make a purchase. Marginal benefits of attending class may include the acquisition of knowledge, participation in discussion, and better preparation for an upcoming examination. Marginal costs may include lost opportunities for sleep, meals, or studying for other classes. In evaluating the discussion of marginal benefits and marginal costs, be careful to watch for sunk costs offered as a rationale for marginal decisions.

1-4 What are the key elements of the scientific method and how does this method relate to economic principles and laws?The key elements include the gathering of data (observation), the formulation of possible explanations (hypothesis), testing the hypothesis, determining the validity of the hypothesis, and repeated testing of hypotheses that have appeared to be valid in prior tests.The scientific method is the technique used by economists to determine economic laws or principles. These laws or principles are formulated to explain and/or predict behavior of individuals or institutions.

1-5 (Key Question) Indicate whether each of the following statements applies to microeconomics or macroeconomics:

a. The unemployment rate in the United States was 4.9 percent in January 2008.b. A U.S. software firm discharged 15 workers last month and transferred the work to India.c. An unexpected freeze in central Florida reduced the citrus crop and caused the price of

oranges to rise.d. U.S. output, adjusted for inflation, grew by 2.2 percent in 2007.e. Last week Wells Fargo Bank lowered its interest rate on business loans by one-half of 1

percentage point.f. The consumer price index rose by 2.8 percent in 2007.

Macroeconomics: (a), (d), and (f)Microeconomics: (b), (c), and (e)

1


1-6 State (a) a positive economic statement of your choice, and then (b) a normative economic statement relating to your first statement.Student answers will vary. Example: (a) The unemployment rate is 4.8 percent; (b) the unemployment rate is too high. In general we treat “what is” statements as positive, “what should be” as normative, but keep an eye out for statements like “at full employment an increase in the production of pizzas should come at the cost of less robots.” Some students may incorrectly identify the statement as normative because of the term “should.”

1-7 (Key Question) Suppose you won $15 on a lotto ticket at the local 7-Eleven and decided to spend all the winnings on candy bars and bags of peanuts. The price of candy bars is $.75 and the price of peanuts is $1.50.

a. Construct a table showing the alternative combinations of the two products that are available.

b. Plot the data in your able as a budget line in a graph. What is the slope of the budget line? What is the opportunity cost of one more candy bar? Of one more bag of peanuts? Do these opportunity costs rise, fall, or remain constant as each additional unit of the product is purchased.

c. How, in general, would you decide which of the available combinations of candy bars and bags of peanuts to buy?

d. Suppose that you had won $30 on your ticket, not $15. Show the $30 budget line in your diagram. Why would this budget line be preferable to the old one?

(a) Consumption alternatives

Goods A B C D E FCandy bars 0 4 8 12 16 20Bags of peanuts

10 8 6 4 2 0

(b)

2


The slope for the budget line above, with candy bars on the horizontal axis, is -0.5 (= -Pcb/Pbp). Note that the figure could also be drawn with bags of peanuts on the horizontal axis. The slope of that budget line would be -2.The opportunity cost of one more candy bar is ½ of a bag of peanuts. The opportunity cost of one more bag of peanuts is 2 candy bars. These opportunity costs are constant. They can be found by comparing any two of the consumption alternatives for the two goods.

(c) The decision of how much of each to buy would involve weighing the marginal benefits and marginal costs of the various alternatives. If, for example, the marginal benefits of moving from alternative C to alternative D are greater than the marginal costs, then this consumer should move to D (and then compare again with E, and so forth, until MB=MC is attained).

(d)

The budget line at $30 would be preferable because it would allow greater consumption of both goods.

1-8 What are economic resources? What categories do economists use to classify them? Why are resources also called factors of production? Why are they called inputs?Economic resources are the natural, human, and manufactured inputs used to produce goods and services. Economic resources fall into four main categories: labor, land (natural resources), real capital (machines, factories, buildings, etc.,) and entrepreneurs. Economic resources are also called factors of production because they are used to produce goods and services. They are called inputs because they go in to a production process (like ingredients go into a bowl to make a cake), with the resulting goods and services also being referred to as output.

1-9 Why isn’t money considered a capital resource in economics? Why is entrepreneurial ability considered a category of economic resources, distinct from labor? What are the major functions of the entrepreneur?Money is not considered a capital resource because money is not productive – it provides access to resources but itself does not directly contribute to the production of goods and services. Additionally, the quantity of money in circulation does not determine an economy’s productive capacity, while the amount of capital and other resources does. Doubling the amount of money in circulation does not change the economy’s physical capacity to produce goods and services.

3


Money is, however, referred as a financial resource and financial capital, reflecting its ability to acquire real economic resources.Entrepreneurial ability and labor are both human resources, but they perform different functions in the productive process. Entrepreneurial ability does not directly produce goods and services; it organizes the resources that do. Labor refers to the human inputs that directly engage in production.Entrepreneurs are risk-takers: They coordinate the activities of the other three inputs for profit—or loss, which is why they are called risk-takers. Entrepreneurs sometimes manage companies that they own, but a manager who is not an owner is not necessarily an entrepreneur but may be performing some of the entrepreneurial functions for the company. Entrepreneurs are also innovators, or perhaps inventors, and profits help to motivate such activities.

1-10 (Key Question) Below is a production possibilities table for consumer goods (automobiles) and capital goods (forklifts):

a. Show these data graphically. Upon what specific assumptions is this production possibilities curve based?b. If the economy is at point C, what is the cost of one more automobile? Of one more forklift?

Explain how the production possibilities curve reflects the law of increasing opportunity costs.

c. If the economy characterized by this production possibilities table and curve were producing 3 automobiles and 20 fork lifts, what could you conclude about its use of available resources?

d. What would production at a point outside the production possibilities curve indicate? What must occur before the economy can attain such a level of production?

(a) See curve EDCBA. The assumptions are full employment, fixed supplies of resources, fixed technology and two goods.

4

Type of Production Production Alternatives

A B C D E

AutomobilesForklifts

030

227

421

612

80


(b) The opportunity cost of one more automobile is 9/2 = 4.5 forklifts. The opportunity cost of one more forklift is 2/6 = 1/3 or .33 automobiles, as determined from the table. Increasing opportunity costs are reflected in the concave-from-the-origin shape of the curve. This means the economy must give up larger and larger amounts of forklifts to get constant added amounts of automobiles—and vice versa.

(c) The economy is underutilizing its available resources. The assumption of full employment has been violated.

(d) Production outside the curve cannot occur (consumption outside the curve could occur through foreign trade). To produce beyond the current production possibilities curve this economy must realize an increase in its available resources and/or technology.

1-11 (Key Question) Specify and explain the typical shapes of the marginal-benefit and marginal-cost curves. How are these curves used to determine the optimal allocation of resources to a particular product? If current output is such that marginal cost exceeds marginal benefit, should more or fewer resources be allocated to this product? Explain.The marginal benefit curve is downward sloping, MB falls as more of a product is consumed because additional units of a good yield less satisfaction than previous units. The marginal cost curve is upward sloping, MC increases as more of a product is produced since additional units require the use of increasingly unsuitable resource. The optimal amount of a particular product occurs where MB equals MC. If MC exceeds MB, fewer resources should be allocated to this use. The resources are more valuable in some alternative use (as reflected in the higher MC) than in this use (as reflected in the lower MB).

1-12 Explain how, if at all, each of the following affects the location of a country’s production possibilities curve:a. The quality of education increases.b. The number of unemployed workers increases.c. A new technique improves the efficiency of extracting copper from ore.d. A devastating earthquake destroys numerous production facilities.(a) Assuming better education translates into better work skills, then productivity should rise and

this would shift the curve outward.(b) Should not affect location of curve. Production moves inward, away from the curve.

Forklifts

5


(c) The curve should shift outward as more production is possible with existing resources.(d) The curve should shift inward with the destruction of resources (capital).

1-13 (Key Question) Referring to the table in question 10, suppose improvement occurs in the technology of producing forklifts but not in the technology of producing automobiles. Draw the new production possibilities curve. Now assume that a technological advance occurs in producing automobiles but not in producing forklifts. Draw the new production possibilities curve. Now draw a production possibilities curve that reflects technological improvement in the production of both products.See the graph for question 1-10. PPC1 shows improved forklift technology. PPC2 shows improved auto technology. PPC3 shows improved technology in producing both products.

1-14 (Key Question) On average, households in China save 40 percent of their annual income each year, whereas households in the United States save less than 5 percent. Production possibilities are growing at roughly 9 percent annually in China and 3.5 percent in the United States. Use graphical analysis of “present goods” versus “future goods” to explain the differences in growth rates.

1-15 Suppose that, on the basis of a nation’s production possibilities curve, an economy must sacrifice 10,000 pizzas domestically to get the 1 additional industrial robot it desires, but that it can get the robot from another country in exchange for 9,000 pizzas. Relate this information to the following statement: “Through international specialization and trade, a nation can reduce its opportunity cost of obtaining goods and thus ‘move outside its production possibilities curve.’”The message of the production possibilities curve is that an individual nation is limited to the combinations of output indicated by its production possibilities curve. International specialization means directing domestic resources to output which a nation is highly efficient at producing. International trade involves the exchange of these goods for goods produced abroad. Specialization and trade have the same effect as having more and better resources or discovering improved production techniques. The output gains from greater international specialization and trade are the equivalent of economic growth.

1-16 (Last Word) Studies indicate that married men on average earn more income than unmarried men of the same age and education level. Why must we be cautious in concluding that marriage is the cause and higher income is the effect?Correlation does not necessarily mean that there is causation. The relationship could be purely coincidental or dependent on some other factor not included in the analysis. It is also possible that higher income is the variable that “causes” marriage.

6


Chapter 1 - Appendix

1A-1 Briefly explain the use of graphs as a way to present economic relationships. What is an inverse relationship? How does it graph? What is a direct relationship? How does it graph? Graph and explain the relationships you would expect to find between (a) the number of inches of rainfall per month and the sale of umbrellas, (b) the amount of tuition and the level of enrollment at a university, and (c) the popularity of an entertainer and the price of her concert tickets. In each case cite and explain how variables other than those specifically mentioned might upset the expected relationship. Is your graph in part b, above, consistent with the fact that, historically, enrollments and tuition have both increased? If not, explain any difference.Graphs can be used to illustrate the relationship between two sets of data. An inverse relationship is when the two variables change in opposite directions. The line is downward sloping. A direct relationship is when the two variables change in the same direction. The line is upward sloping. Statements (a) and (c) illustrate direct relationships. Statement (b) illustrates an inverse relationship. The inverse relationship is assuming that everything else remains equal.

1A-2 (Key Appendix Question) Indicate how each of the following might affect the data shown in the table and graph in Figure 2 of this appendix:a. GSU’s athletic director schedules higher-quality opponents.b. An NBA team locates in the city where GSU plays.c. GSU contracts to have all its home games televised.(a) More tickets are bought at each price; the line shifts to the right.(b) Fewer tickets are bought at each price, the line shifts to the left.(c) Fewer tickets are bought at each price, the line shifts to the left.

1A-3 (Key Appendix Question) The following table contains data on the relationship between saving and income. Rearrange these data into a meaningful order and graph them on the accompanying grid. What is the slope of the line? The vertical intercept? Interpret the meaning of both the slope and the intercept. Write the equation which represents this line. What would you predict saving to be at the $12,500 level of income?

Income(per year)`

Saving(per year)

$15,000010,0005,00020,000

$1,000-50050001,500

Income column: $0; $5,000; $10,000, $15,000; $20,000. Saving column: $-500; 0; $500; $1,000; $1,500. Slope = 0.1 (= $1,000 - $500)/($15,000 - $10,000). Vertical intercept = $-500. The slope shows the amount saving will increase for every $1 increase in income; the intercept shows the amount of saving (dissaving) occurring when income is zero. Equation: S = $-500 + 0.1Y (where S is saving and Y is income). Saving will be $750 at the $12,500 income level.

1A-4 Construct a table from the following data shown on the accompanying graph. Which is the dependent variable and which the independent variable? Summarize the data in equation form.

7


Study time(hours)

024689

Exam scores

1030507090

100

The dependent variable (the effect) is the exam score and the independent variable (the cause) is the study time.The equation is:

Exam score=10+(50−30 )/ (4−2 )×Study time=10+20/2×Study time=10+10×Study timeProof: Exam score when study time is 6 hours: =10+ (10×6 )=10+60=70 as shown in the table above

1A-5 Suppose that when the interest rate on loans is 16 percent, businesses find it unprofitable to invest in machinery and equipment. However, when the interest rate is 14 percent, $5 billion worth of investment is profitable. At 12 percent interest, a total of $10 billion of investment is profitable. Similarly, total investment increases by $5 billion for each successive 2-percentage point decline in the interest rate. Describe the relevant relationship between the interest rate and investment in words, in a table, graphically, and as an equation. Put the interest rate on the vertical axis and investment on the horizontal axis, and in your equation use the form i = a + bI, where i is the interest rate, a is the vertical intercept, b is the slope of the line (which is negative), and I is the level of investment. Comment on the advantages and disadvantages of the verbal, tabular, graphic, and equation forms of description.

8


Interestrate(in percent)

Amount ofinvestment(billions of dollars)

16141210 8 6 4 2 0

$ 0 5 10 15 20 25 30 35 40

When the interest rate is 16%, investment spending will be zero. When the interest rate is 14%, investment spending will be $5 billion. For each successive drop of 2 percentage points in the interest rate, investment spending will increase by $5 billion.Using equation i=a−bIi=16−[ (16−14 )/ (5−0 ) ]×I

=16−(25 )I

Proof: Substituting data from the table, when I is $25 billion, i = 16 -2/5(25) = 16 - 10 = 6 percent.The verbal presentation can be made, but is hard to visualize. The tabular presentation is precise; all the facts are there, neatly arrayed, and it is easier to visualize than the verbal one. The graphic presentation shows at a glance the relationship between the variables and, moreover, is best for showing large changes, that is, movements of a whole curve. However, the graph requires careful drafting to ensure that it is as accurate as the table. The equation is as precise as the table and, moreover, describes all the intermediate points not set out in the table. For most people, though, the equation form is probably the hardest to visualize.

9


1A-6 Suppose that C = a + bY, where C = consumption, a = consumption at zero income, b= slope, and Y = income.a. Are C and Y positively related or are they negatively related?b. If graphed, would the curve for this equation slope upward or downward?c. Are the variables C and Y inversely related or directly related?d. What is the value of C if a =10, b =.50, and Y = 200?e. What is the value of Y if C = 100, a = 10, and b = .25?(a) C and Y are positively related because the slope, b, is positive.(b) The curve would slope upward because the slope is positive.(c) C and Y are directly related because C and Y are positively related.(d) C = 110.(e) Y = 360.

10


1A-7 (Key Appendix Question) The accompanying graph shows curve XX and tangents at points A, B, and C. Calculate the slope of the curve at these three points.

ANSWERS TO END-OF-CHAPTER QUESTIONS2-1 Contrast how a market system and a command economy try to cope with economic scarcity.

A market system allows for the private ownership of resources and coordinates economic activity through market prices. Participants act in their own self-interest and seek to maximize satisfaction or profit through their own decisions regarding consumption or production. Goods and services are produced and resources are supplied by whoever is willing to do so. The result is competition and widely dispersed economic power.The command economy is characterized by public ownership of nearly all property resources and economic decisions are made through central planning. The planning board, appointed by the government determines production goals for each enterprise. The division of output between capital and consumer goods is centrally decided based on the board’s long-term priorities

2-2 How does self-interest help achieve society’s economic goals? Why is there such a wide variety of desired goods and services in a market system? In what way are entrepreneurs and businesses at the helm of the economy but commanded by consumers?The motive of self-interest gives direction and consistency to the economy. The primary driving force of the market system is self-interest. Entrepreneurs try to maximize their profits; property owners want the highest price for their resources; workers choose the job with the best wages, fringe benefits and working conditions. Consumers apportion their expenditures to maximize their utility, while seeking the lowest possible prices. As individuals express their free choice, the economy is directed to produce the most wanted goods at the lowest possible cost.Each individual consumer will choose a variety of goods and services that in combination will maximize his/her satisfaction (utility). There is a wide variety because individual wants are diverse. To maximize profits, producers must respond to the desires of the individual consumer. Although producers are free to choose what products they will produce, if the producers are to maximize profits, these good and services must be what consumers desire. Entrepreneurs can drive the economic ship where they want (at least for a while), but the ship will run aground (businesses will fail) if entrepreneurs at the helm don’t listen to the consumers that command them.

2-3 Why are private property, and the protection of property rights, so critical to the success of the market system?The ownership of private property and the protection of property rights encourages investment, innovation, and, therefore, economic growth. Property rights encourage the maintaining of the property and they facilitate the exchange of the property.

2-4 What are the advantages of using capital in the production process? What is meant by the term “division of labor”? What are the advantages of specialization in the use of human and material resources? Explain why exchange is the necessary consequence of specialization.Capital goods enable producers to operate more efficiently and to produce more output. “Division of labor” means that workers perform those tasks that are best suited to their individual abilities and skills. The advantages of specialization for workers are that they can choose work according to their natural aptitudes, have the opportunity to perfect those skills, and save time in not having to shift continually from one task to another. Material resources will be developed and adapted for a specific use. On a regional basis, each region will produce those products for which it is best suited. By specializing in its comparative advantage, each region or set of human and material resources is being used to maximize efficiency.

11


When resources are specialized, they are no longer self-sufficient. To obtain the goods and services one needs, exchange is necessary. Also, specialization will result in a surplus of a specific good being produced. The surplus of one good will be exchanged for the surplus production of other goods.

2-5 What problem does barter entail? Indicate the economic significance of money as a medium of exchange. What is meant by the statement: “We want money only to part with it”?Barter requires the “double coincidence of wants.” If someone wants something, he/she will have to find someone who wishes to part with that good and at the same time wishes to exchange the good for something that the first party wishes to part with. With money as a medium of exchange, one knows the purchase price of the item to be purchased and it relative price to other items. Money is a very convenient common denominator, a common measure of value that is also used as a medium of exchange. Money also encourages specialization. Without money, workers and other resources could not be paid except in the output produced. All those who participated in the production of the good would have to collectively exchange it for all the goods and service desired by the resource owners.Money itself has value only in relation to the resources, goods, and services that can be obtained with it. When people say that they want money, they really mean that they want the things that money can buy. In this sense, money imparts value only when someone parts with it.

2-6 Evaluate and explain the following statements:a. The market system is a profit-and-loss system.b. Competition is the disciplinarian of the market economy.(a) The quotation is accurate. In a market system, producer decisions are motivated by the

attempt to earn profits. Those products that enable a firm to earn at least a normal profit (minimum compensation for the entrepreneur for his/her time and talents) will be produced. If the product cannot be produced for a profit—in other words, if losses are involved in production—the capitalist firm will respond by seeking lower cost production methods and may halt the production of goods completely. Because profits and/or losses are the motivation behind the fundamental decisions made in a market system, it could be called a “profit and loss economy.”

(b) Competition provides discipline in two ways. First, it forces firms to seek the least-cost production methods or face being driven out of business by their rivals. Second, it prevents successful producers from charging whatever the market will bear. Competition keeps prices at a level where total revenue will just cover the total cost of production including a normal profit, but no more in the long run. If sellers try to charge a price that will earn them economic profits, new firms will enter the industry, increasing supply, and lowering prices until the economic profits are eliminated. Competition is indispensable in this role, because otherwise some other method would have to be found to direct firms to use the least-cost production technique and to charge a price that provides only a normal return. Where competition does not exist, such as in natural monopolies like public utility companies, regulators or publicly owned companies must assume the role of disciplinarian. Experience has shown that this is a difficult process and does not achieve the same results as easily as a competitive market situation.

2-7 In the 1990s thousands of “dot-com” companies emerged with great fanfare to take advantage of the Internet and new information technologies. A few, like Yahoo, eBay, and Amazon, generally thrived and prospered, but many others struggled and eventually failed. Explain these varied outcomes in terms of how the market system answers the question “What goods and services will be produced?”

12


The expectation of economic profits lured many new firms into the “dot-com” industries. However, because of a lack of information and a market unable to sustain so many firms, many failed to realize even a normal profit and failed. [Technically many of the early dot-coms were not earning economic profits, but their shareholders were reaping huge windfalls from the stock market speculation.] When these new firms found that they could not profitably produce in this industry, they dropped out and the industry declined. The problem was not so much one of consumer sovereignty – consumers demonstrated an interest in these services. The heavy competition of so many firms trying to establish themselves in the market led to prices that were insufficient to cover economic costs. In a few cases, most notably Napster (an internet company that allowed uses to download music at little or no cost), government restrictions on activities (copyright infringement in Napster’s case) led to firm failure (at least for a time).

2-8 (Key Question) With current technology, suppose a firm is producing 400 loaves of banana bread daily. Also, assume that the least-cost combination of resources in producing those loaves is 5 units of labor, 7 units of land, 2 units of capital, and 1 unit of entrepreneurial ability, selling at

prices of $40, $60, $60, and $20, respectively. If the firm can sell these 400 units at $2 per unit, will it continue to produce banana bread? If this firm’s situation is typical for the other makers of banana bread, will resources flow to or away from this bakery good?Total Profits = Total Cost – Total RevenueTotal Cost = Presource * Qresource and Total Revenue = Price * Qsold

Total Cost = ($40 * 5 units of labor) + ($60 * 7 units of land) + ($60 * 2 units of capital) + ($20 * 1 unit of entrepreneurial ability) = $200 + $420 + $120 + $20 = $760.Total Revenue = $2 * 400 loaves of banana bread = $800.Total Profits = $800 - $760 = $40. The firm will continue to produce as it is earning economic profits. If this firm is typical of the banana bread industry, more resources will flow toward banana bread as other potential firms are attracted to the economic profits in the industry.

2-9 (Key Question) Assume that a business firm finds that its profit it greatest when it produces $40 worth of product A. Suppose also that each of the three techniques shown in the table on page 43 will produce the desired output.

13


Resource Units Required

ResourcePrice per unitof resource

Technique1

Technique2

Technique3

LaborLandCapitalEntrepreneurial ability

$3 4 2 2

5224

2442

3254

a. With the resource prices shown, which technique will the firm choose? Why? Will production entail profit or losses? What will be the amount of profit or loss? Will the industry expand or contract? When will that expansion end?

b. Assume now that a new technique, technique 4, is developed. It combines 2 units of labor, 2 of land, 6 of capital, and 3 of entrepreneurial ability. In view of the resource prices in the table, will the firm adopt the new technique? Explain your answer.

c. Suppose that an increase in labor supply causes the price of labor to fall to $1.50 per unit, all other resource prices being unchanged. Which technique will the producer now choose? Explain.

d. “The market system causes the economy to conserve most in the use of those resources that are particularly scarce in supply. Resources that are scarcest relative to the demand for them have the highest prices. As a result, producers use these resources as sparingly as is possible.” Evaluate this statement. Does your answer to part c, above, bear out this contention? Explain.

(a) The firm will choose technique 2 because it produces the output at the least cost ($34 compared to $35 for techniques 1 and 3). Economic profit will be $6 (= $40 - $34), causing the industry to expand. Expansion in this industry will continue until prices decline to where total revenue equals total cost of $34 and no additional firms will want to enter the industry.

(b) The firm will adopt technique 4 because its cost is now lowest at $32.(c) The firm will choose technique 1 because its cost is now lowest at $27.50.(d) The statement is logical. Increasing scarcity of a resource causes its price to rise. Firms

ignoring higher resource prices will become high-cost producers. Firms switching to the less expensive inputs become lower-cost producers and earn higher profits than high-cost producers. The market system, therefore, forces producers to conserve on the use of highly scarce resources. Question 9c confirms this: Technique 1 was adopted because labor had become less expensive.

2-10 (Key Question) Some large hardware stores such as Home Depot boast of carrying as many as 20,000 different products in each store. What motivated the producers of those individuals to make them and offer them for sale? How did producers decide on the best combinations of resources to use? Who made these resources available, and why? Who decides whether these particular hardware products should continue to be produced and offered for sale?The quest for profit led firms to produce these goods. Producers looked for and found the least-cost combination of resources in producing their output. Resource suppliers, seeking income, made these resources available. Consumers, through their dollar votes, ultimately decide on what will continue to be produced.

2-11 What is meant by the term “creative destruction”? How does the emergence of MP3 (iPod) technology relate to this idea?

14


Creative destruction refers to the process by which the creation of new products and production techniques destroys the market positions of firms committed to producing only existing products or using outdated methods. The ability to download and store a large number of songs, and the superior quality of MP3 is causing a decline in the CD industry, just as CDs once replaced cassette tapes, which had previously replaced phonographs (records).

2-12 In a sentence, describe the meaning of the phrase “invisible hand.”Market prices act as an “invisible hand,” coordinating an economy by rationing what is scarce and providing incentives to produce the most desired goods and services.

2-13 In market economies, firms rarely worry about the availability of inputs to produce their products, whereas in command economies input availability is a constant concern. Why the difference?In market economies, buyers of inputs know that sellers want to make resources available for sale because that is how they earn their profits. If there aren’t enough resources available, prices will rise until suppliers come forth with the desired amounts. In command economies the availability of inputs depends on what was specified in the plan, and how well the plan was executed. There is no opportunity (at least not legally) to offer greater payments to get those resources provided.

2-14 Distinguish between the resource market and product market in the circular flow model. In what way are businesses and households both sellers and buyers in this model? What are the flows in the circular flow model?The resource markets are where the owners of the resources (the households) sell their resources to the buyers of the resources (businesses). In the product markets, businesses sell the goods and services they have produced to the buyers of the goods and services, the households.Households (individuals) either own all economic resources directly or own them indirectly through their ownership of business corporations. These households are willing to sell their resources to businesses because attractive prices draw them into specific resource markets. Businesses buy resources because they are necessary for producing goods and services. The interaction of the buyers and sellers establishes the price of each resource. In the product market, businesses are the sellers and householders are the buyers; their role in the market has been reversed. Each group of economic units both buys and sells.One flow is the flow of real goods and services (including resource services) and the other flow is the flow of money (money income, consumption expenditures, revenue, production costs).

2-15 (Last Word) What explains why millions of economic resources tend to get arranged logically and productively rather than haphazardly and unproductively?

15


The institution of private property is a primary reason why resources are arranged logically and

productively. Private property eliminates randomness to the allocation of resources, as property owners act in deliberate ways to protect and maximize the benefits from their property. Owners pursue the greatest possible returns from their property, drawing resources to their most valued uses. Through the interaction of millions of economic agents all trying to use their private property to maximize well-being, a complex, logical, and productive arrangement of resources results. Slopes: at A = +4; at B = 0; at C = -4.

1A-8 In the accompanying graph, is the slope of curve AA’ positive or negative? Does the slope increase or decrease as we move along the curve from A to A’? Answer the same two questions for curve BB’.Slope of AA’ is positive (rising from left to right). The slope increases as we move from A to A’.Slope of BB’ is negative (dropping from left to right). The slope becomes more negative, thereby decreasing, as we move from B to B’.The slopes of both curves are tending to infinity as they continue to move to the right.

16

Documents

Chapter 2 - Seneca Valley School District / Overvie · Web viewChapter 02 - The Market System and the Circular Flow 1 26 1 Chapter 2 ANSWERS TO END-OF-CHAPTER AND APPENDIX QUESTIONS