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Reproduced by Pearson Addison-Wesley from electronic files supplied by author.

Copyright 2005 Pearson Education, Inc.Publishing as Pearson Addison-Wesley, 75 Arlington Street, Boston, MA 02116

All rights reserved. This manual may be reproduced for classroom use only. Printed in the United States of America.

ISBN 0-321-23359-X

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III

Introduction This book is one of six test banks, each carefully crafted to be part of the most complete package of test banks ever offered to support a beginning economics text-book. Three of the test banks are designed to accom-pany Michael Parkins Microeconomics, Seventh Edition and three accompany Michael Parkins Macroeconomics, Seventh Edition. The complete set of six books com-prises Microeconomics Test Bank, Volumes I, II, and III and Macroeconomics Test Bank, Volumes I, II, and III.

These books have undergone major revisions for this edition. Both the Microeconomics Test Bank Volumes I and II and the Macroeconomics Test Bank Volumes I and II now contain only multiple choice questions. The multiple choice questions that in previous editions were in Volume III of the test banks have now been melded into Volumes I and II. Volume III for both the Microeconomics Test Bank and Macroeconomics Test Bank now contains large numbers of essay questions, numerical questions, graphing questions, and extended problems. All of the different types of questions in Volume III have answers suitable for distribution to your students.

Test Bank Principles Three principles guided the writing and revising of the questions:

The questions should be fail insofar as the topic of the questions has been explained in the textbook.

A question should not be a guessing game forcing the students to puzzle out what the question asks.

An instructor must be absolutely secure in the knowledge that each question contains material covered in the textbook.

I endeavored to insure that all questions meet all the criteria so that they are, as Donald Dutkowsky put it, bullet proof.

Seventh Edition Revisions We have made substantial revisions in preparing the test banks for the Seventh Edition:

All the questions have been reviewed, to ensure consistency with the text and clarity for the stu-dents. Questions dealing with material eliminated from the seventh edition of the textbook were de-leted and a large number of new questions were added to cover both the new as well as the old top-ics in the seventh edition. The new questions are identified by an asterisk (*) following the style of question.

The artwork was reviewed and changed to remain consistent with the seventh edition of the text-book.

To the greatest extent possible, the questions have been ordered so that they follow the order the ma-terial is presented in the corresponding textbook chapter. You generally will find all questions on the same topic clustered together so you can easily select the one you want. In addition, within each chapter the multiple choice questions are separated by each major section of the text chapter so that if you assign to the students only part of a chapter, it will be easy to select questions from that specific part.

Many new essay, numeric, and graphing questions have been added, all with suggested answers. You can use these answers to show students the type of answer that you were expecting. Volume III is now specialized to include these types of questions.

The test banks are available in both a user-friendly computerized test bank and in Word doc files. For some instructors, the ease of simply cutting and pasting from the Word files will exceed the utility of the powerful computerized test bank. With this edition, we accommodate both preferences.

P r e f a c e

I V P R E F A C E

Volumes I and II Taken together, there are nearly 15,000 multiple choice questions in Volumes I and II of the test bank. These questions have been written by many contribu-tors. I have edited the questions to ensure that each conformed with the writing style established in the book because this style has been carefully crafted for maximum student comprehension. I also arranged the questions so that they are in the same order that the topics are presented within the textbook. In addition, among questions dealing with a similar topic, the ques-tions are ordered with non-numerical questions first, questions dealing with a numerical table second, and questions dealing with a figure third.

In addition to questions from the text, at the end of each chapter Volume I also contains multiple choice questions that are either the same as or else closely re-lated to the questions in the Study Guide and on the MyEconLab student website for the book. Each of these questions is identified as to its source. So, if you have assigned these student supplements to your class, you have the means of rewarding students who are using them by asking questions drawing on what they have been studying.

The questions in each chapter of Volume I and Vol-ume II are drawn from material covered only in that chapter. A new feature of Volume II are Part Review questions. These sections feature questions that are drawn from material covered in more than one chapter in each Part. These questions are all new. You can use these questions if you want more integrative questions that lead students to think about broader issues.

I have been teaching principles classes for over two decades, have written hundreds of exams, and won several teaching awards. Nonetheless, I was stunned by the quality of the questions in the test banks. I lost count of the number of times that I marveled at a ques-tion and wished that I had thought of it. While creat-ing this test bank took significantly more effort than preparing an ordinary test bank, I am sure that the quality you will find made the task worthwhile.

Volume III Volume III has been completely redone. It now con-sists of essay questions, numeric questions, graphing questions, true or false questions, and extended prob-lems. Within each book, you will find each type of

question grouped togetherthat is, the essay questions for each chapter are first, followed by the nu-meric/graphing questions for each chapter, and so on. In this fashion, if you want to write a strictly essay question exam, it will be easy to do so. Of course, within each chapter, the questions are arranged in the same order that the topics appear in the textbook.

The extended problems need new to this edition of the test banks. For each chapter there are 3 to 5 extended problems. These questions, are, as the name implies, longer questions. Sometimes the questions for a chapter build upon each other; other times the questions are independent. These questions can be used on exam. However, they may also be given to the students and used as homework. I think the best way to view these questions is as a valuable supplement to the out-standing questions already in the textbook.

How to Assemble a Test Because I have been teaching while working on these test banks, it has been natural to use them to create tests for my class. Having thousands of excellent ques-tions immediately at hand made writing examinations an easy and (almost) pleasant task.

Because my class consists of between 1,500 and 2,100 students a semester, I use exclusively multiple choice questions. For each test, I decide a priori approximately how many questions I want from each chapter. Clearly my sense of the relative importance of the material plays a role here. I think this reflection is crucial be-cause it ensures that my examinations cover the mate-rial that I deem most important for my students to know.

Because I write my tests using Word, I start the actual writing process by taking an old test and eliminating all but one question. Then, using the Word test bank files, I locate a question that I want to use, copy the question from the test bank file to my test, and immediately change the question number so that it is correct. As it happens, I prefer a slightly different paragraph style for my questions and answers than what is used in the test bank. Using the Word Format Painter (the paint brush symbol) I copy the format I prefer from the old question that I saved to the newly pasted question. Once I have a new question formatted with my pre-ferred paragraph style, I delete the old question.

I change the style of the question and answers because I prefer a slightly different font and because I format the

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question and the first three answers using the keep with next command from Words Format-Paragraph-Line and Page Breaks menu. The last answer for the question does not have this command. By using the keep with next command for the question and first three answers, I ensure that I do not have a question or answer break across a page.

As I copy and paste each question, I keep track of how many questions I have from each chapter. I do not slav-ishly adhere to my initial decision of how many ques-tions I want from each chapter, but I also do not stray too far.

Finally, I print an initial copy of my examination and proofread it to be sure that I have not inadvertently given away the answer to one question with another question. I make any necessary corrections and am done. Given the quality of the test banks, I have that found I can easily write a high-quality 35-40 question examination within a little more than an hour.

Final Comments Just as Sir Isaac Newton stood on the shoulders of the giants who came before him, so, too do these test banks reflect the superb work of the authors who initially wrote and compiled them. So it is entirely fitting to thank them: Peter von Allmen of Moravian College Sue Bartlett of the University of South Florida Jill Boylston Herndon of the University of Florida Kevin Carey of American University Leo Chan of the University of Kansas Carol Dole of the State University of West Geor-

gia Donald H. Dutkowsky of Syracuse University Andrew Foshee of McNeese State University James Giordano of Villanova University John Graham of Rutgers University Veronica Z. Kalich of Baldwin-Wallace College Sang Lee of Southeastern Louisiana University Melinda Nish of Salt Lake Community College

Terry Olson of Truman State University Ed Price of Oklahoma State University Rochelle L. Ruffer of Youngstown State University Virginia Shingleton of Valparaiso University Della Sue of Marist College Nora Underwood of the University of California,

Davis Robert Whaples of Wake Forest University Peter A. Zaleski of Villanova University Contributing questions for the Seventh edition micro-economic chapters is: Constantin Oglobin of Georgia Southern Univer-

sity Constantin also created all the Extended Problems for the entire book! Contributing questions for the Seventh edition macro-economic chapters is: William Mosher of Clark University I have tried to make these Test Banks as helpful and useful as possible. Undoubtedly I have made some mis-takes; mistakes that you may see. I have a standing offer in the Study Guide asking students who find any errors to notify me and promising that I will acknowledge them in all future editions of the Study Guide. I will make the same offer here: If you find any errors or have any comments or questions, please let me know and, if you want, I will note your help in all future editions of the test banks. And so keeping this promise:

Dr. B. N. Ghosh of Eastern Mediterranean Uni-versity in North Cyprus. Dr. Ghosh found several errors and I greatly appreciate his efforts!

My address is below, or you can reach me via E-mail at [email protected]. Mark Rush Economics Department University of Florida Gainesville, Florida 32611 December 2003

VII

Preface iii

ESSAY QUESTIONS Chapter 1 What is Economics? 1

Appendix Graphs in Economics 7

Chapter 2 The Economic Problem 9

Chapter 3 Demand and Supply 15

Chapter 4 Elasticity 21

Chapter 5 Efficiency and Equity 29

Chapter 6 Markets in Action 37

Chapter 7 Utility and Demand 47

Chapter 8 Possibilities, Preferences, and Choices 53

Chapter 9 Organizing Production 59

Chapter 10 Output and Costs 63

Chapter 11 Perfect Competition 69

Chapter 12 Monopoly 77

Chapter 13 Monopolistic Competition and Oligopoly 85

Chapter 14 Regulation and Antitrust Law 93

Chapter 15 Externalities 101

Chapter 16 Public Goods and Common Resources 109

Chapter 17 Demand and Supply in Factor Markets 115

Appendix Market Power in the Labor Market 121

Chapter 18 Economic Inequality 123

Chapter 19 Uncertainty and Information 129

Chapter 20 Trading With the World 133

Tab l e o f Con ten t s

V I I I

NUMERIC AND GRAPHING QUESTIONS Chapter 1 What is Economics? 143





















I X

TRUE OR FALSE QUESTIONS Chapter 1 What is Economics? 263


















Appendix Market Power in the Labor Market 299




X

EXTENDED PROBLEMS Chapter 1 What is Economics? 309




















1

CHAPTER 1 WHAT IS ECONOMICS?

Essay Questions Topic: Scarcity Skill: Recognition 1) What do economists mean when they discuss

scarcity? Answer: Scarcity occurs whenever peoples wants

exceed the ability of the available resources to meet these wants. Because peoples wants are ef-fectively infiniteit is always possible to imagine more good things to want to havewants will always exceed what can be produced with the available resources, and so scarcity will always be present.

Topic: Scarcity Skill: Conceptual 2) What is the relationship between wants, factors of

production, scarcity, and choices? Discuss the re-lationship for an individual and for a society.

Answer: A person faces scarcity whenever his or her wants exceed what he or she can obtain using his or her resources. Because the person cannot fulfill all of his or her wants, the person is forced to choose which wants will be satisfied and which wants will remain unsatisfied. The same results hold true for a society. All societies face scarcity because peoples wants are essentially infinite, so that the factors of production available are not sufficient to fulfill everyones wants. Because of this fact, societies must make choices about which (and whose) wants will be satisfied and which (and whose) wants will remain unsatisfied.

Topic: Scarcity Skill: Conceptual 3) Why do economists say that even very rich people

face scarcity? Answer: A person faces scarcity whenever his or her

wants exceed what he or she can obtain using his or her resources. Even very rich people want things that they cannot have. An older rich per-son, for instance, might want to have all of his or her youthful energy, but medical science cannot

(yet) provide this service. Alternatively, another rich person might enjoy life so much that he or she wants 25 hours in a day in order to have more time for more enjoyment. But, such a want is im-possible. By way of another, perhaps more realis-tic example, Malcom Forbes was the founder of Forbes magazine and was very rich. However, he did not win every piece of art that he bid upon at auctions. Even though Mr. Forbes was very rich, he still passed on some art when the price got so high that he thought given his resources, the price exceeded what he was willing to pay. Mr. Forbes wanted the art, but he was not willing to bid higher in order to win it. Mr. Forbes faced scar-city.

Topic: Scarcity Skill: Conceptual 4) Explain why both rich and poor people experi-

ence scarcity. Answer: Scarcity exists when peoples wants exceed

their ability to satisfy the wants. Peoples wants are literally infinite, so just as a poor person can want more, so too can a richer person. Therefore both rich and poor experience scarcity.

Topic: Scarcity Skill: Conceptual 5) What is the difference between scarcity and pov-

erty? Answer: Scarcity exists when availability is less than

people want. Poverty exists when availability is less than people need. Everyone suffers scarcity; only an unfortunate minority suffers poverty.

Topic: Definition of Economics Skill: Recognition 6) Define economics and describe its branches of

study. Answer: Economics is the social science that studies

the choices made by individuals, businesses, gov-ernment, and entire societies as they cope with scarcity. It has two branches, microeconomics and macroeconomics. Microeconomics is the study of the choices made by individuals and businesses,

2 C H A P T E R 1

the way they interact, and the influence that gov-ernments exert on these choices. Macroeconomics is the study of the aggregate (total) effects on the national economy and the global economy of the choices that individuals, businesses, and govern-ments make.

Topic: Microeconomics and Macroeconomics Skill: Recognition 7) What is the difference between microeconomics

and macroeconomics? Answer: Microeconomics studies the decisions of

smaller economic actors, such as individual con-sumers or individual firms, and how the govern-ment can affect these decisions, say through how it regulates an industry. Macroeconomics studies the aggregate, or economy-wide, consequences of the decisions made by individuals and firms. Mac-roeconomics also studies the aggregate effects of government policies, such as the Federal Reserves decisions to raise or lower interest rates.

Topic: Microeconomics and Macroeconomics Skill: Conceptual 8) What is the difference between microeconomics

and macroeconomics? Give an example of an issue each studies.

Answer: Essentially microeconomics studies individ-ual units within the economy, such as the choices made by individual consumers or individual firms. Macroeconomics studies the overall or ag-gregate economy. Microeconomics examines the factors that affect employment at an individual firm. Macroeconomics examines the factors that affect economy-wide unemployment.

Topic: Microeconomics and Macroeconomics Skill: Conceptual 9) Below is a students answer to the question What

is microeconomics? If you were the instructor, how would you correct the students answer?

Microeconomics is the study of how government influences the choices made by individuals and businesses and of the performance of the whole national economy.

Answer: The answer is partially correct. Microeco-nomics is the study of the choices that individuals and businesses make, the way these choices inter-act in markets, and the influence of the govern-ment. But the performance of the national econ-

omy is the subject of macroeconomics, not microeconomics.

Topic: Human Capital Skill: Conceptual 10) Chinas population is about 1.2 billion, while the

population of the United States is about 280 mil-lion. This fact means that China has much more human capital than the U.S. does. True or false? Explain your answer.

Answer: False. Population can measure the quantity of a nations labor resource, but the population numbers dont tell us anything about skills that this labor force obtained from education, on-the-job training, and work experience, which are called human capital. Thus, the population num-bers in the statement only tell us that China is likely to have more labor than the United States, but it does not necessarily mean that it also has more human capital.

Topic: Entrepreneurship Skill: Recognition 11) Explain what entrepreneurship is and why it is

considered a factor of production. Answer: Entrepreneurship is the resource (the people)

that runs businesses. Entrepreneurs organize the other resources, land, labor, and capital. It is a fac-tor of production because people with the desire and talent to successfully organize a business are needed to run businesses.

Topic: Self-Interest and Social Interest Skill: Conceptual 12) An analyst on a local news channel argues that the

recent corporate scandals demonstrated very clearly that self interest always contradicts social interest. Do you agree or disagree? Substantiate your answer.

Answer: You should disagree. The recent corporate scandals only show that self interest might contra-dict social interest. But they dont prove that this is necessarily the case as we can find many real-world examples of how people guided by self-interest promote societys well-being. In fact, un-der the market system the whole economy oper-ates through the decisions made by self-interested individuals. And countries such as the United States have proven to be more successful in pro-moting social interest than were centrally planned, or communist, economies where peo-

W H A T I S E C O N O M I C S ?

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ples self interest was suppressed and all important economic decisions were made by government.

Topic: Tradeoffs Skill: Conceptual 13) What is a tradeoff? Give an example. Answer: A tradeoff occurs when one thing must be

given up to get another. Tradeoffs are pervasive; at the personal level, students tradeoff time spent studying for time they otherwise could have spent socializing.

Topic: Opportunity Cost Skill: Recognition 14) What is opportunity cost? Answer: Opportunity cost is the highest-valued alter-

native given up when selecting an action. For in-stance, the opportunity cost of studying an hour is whatever the highest-valued alternative would have been for the hour spent studying.

Topic: Opportunity Cost Skill: Conceptual 15) What is an opportunity cost? Give an example of

an opportunity cost that is paid in money and an opportunity cost that is not explicitly paid. For each example, explain why you think this is an opportunity cost.

Answer: An opportunity cost of something is the highest-valued alternative you give up to get it. An example of an opportunity cost paid in money is the cost of tuition that a student pays to get his or her college degree. This expenditure is an op-portunity cost because to get a college degree, the student gives up goods and services that he or she would have bought for the money spent on tui-tion. If this student quits a job to go to college, the student also gives up the money he or she could have earned working. This opportunity cost is an example of an opportunity cost that is not explicitly paid in money.

Topic: Opportunity Cost Skill: Conceptual 16) Your friend is preparing for this exam and in your

practice session makes the following statement: Instead of attending microeconomics class for two hours, Kiki could have played tennis or watched a movie. Therefore, the opportunity cost of attending class is the tennis and the movie she

had to give up. Is your friends analysis correct or not? Explain your answer.

Answer: Your friends analysis is incorrect. The op-portunity cost of an action is the highest-valued alternative forgone, not all alternatives forgone. Kikis opportunity cost of studying for her exam is either the tennis or the movie, whichever she would have done had she not studied.

Topic: Opportunity Cost Skill: Conceptual 17) Rather than go out to eat by yourself, you decide

to stay at home and fix dinner for yourself and your two roommates. Your roommates applaud your decision. Your first roommate tells you that your decision to eat at home has no opportunity cost because you already have all the dinner in-gredients in your pantry. Is this roommates com-ment correct?

Answer: Your first roommates comment is incorrect. The opportunity cost of preparing dinner at home is whatever is the highest-valued alternative for-gone, which, given your choice boiled down to staying home or going out, is going out to eat. Hence the opportunity cost of fixing dinner at home is going out to eat.

Topic: Opportunity Cost Skill: Conceptual 18) A student can spend the next hour studying for a

finance test, hiking along the Oregon coast, watching a rerun of Buffy the Vampire Slayer on television, or napping. If the student decides to study, what is the opportunity cost of her choice: hiking, watching television, or napping?

Answer: With the information given, it is impossible to determine the opportunity cost. The opportu-nity cost is the highest-valued alternative forgone and the problem does not give the students rank-ing of the options. For instance, if the student thinks that if she had not studied she would have watched Buffy, then watching Buffy is the oppor-tunity cost. However, if the student thinks that if she were not studying, she would be strolling along the beach, then the beach walk is the oppor-tunity cost.

4 C H A P T E R 1

Topic: Marginal Benefit and Marginal Cost Skill: Recognition 19) Define marginal cost and marginal benefit. Answer: Marginal cost is the opportunity cost of a

small (one-unit) increase in an activity. Marginal benefit is the benefit of a small (one-unit) increase in an activity.

Topic: Marginal Benefit Skill: Recognition 20) What is the difference between a total benefit and

a marginal benefit? Answer: The total benefit is all the benefit from all of

an activity. The marginal benefit is the additional benefit from an additional amount of an activity.

Topic: Incentives, Marginal Cost and Marginal Benefit Skill: Conceptual 21) In New State, the bottling law requires that peo-

ple get a refund of five cents when they return an empty bottle or can. Why does the state pay peo-ple to return bottles? In your answer, be sure to mention the role played by incentives.

Answer: Policy makers know that people making choices respond to incentives. Instead of throwing away bottles and cans, people will now bring the used bottles and cans to the designated areas for recycling in order to receive their payment. Thus policy makers have taken advantage of peoples decision making by increasing the marginal bene-fit of returning bottles in order to reduce litter and clean the environment.

Topic: Incentives, Marginal Cost and Marginal Benefit Skill: Conceptual 22) If the government raises the tax on cigarettes,

what is the effect on peoples incentives and choices?

Answer: The government raises the tax on cigarettes to discourage smoking. With a higher tax the price of cigarettes rises. The opportunity cost of smoking increases, which gives people incentive to cut their consumption of cigarettes.

Topic: Positive and Normative Skill: Recognition 23) What is the difference between positive and nor-

mative statements? Answer: Positive statements tell what is and norma-

tive statements tell what ought to be. Positive statements can be tested to determine if they are correct or not, while normative statements use value judgments and so cannot be tested. For ex-ample, two economists might agree on the posi-tive assertion that if the government spent its funds purchasing pharmaceutical drugs for poor older Americans rather than poor children, then poor older Americans would use more drugs and poor children would use fewer. But they might disagree on the normative conclusion of whether the government should pursue this policy. One economist might argue It is not fair to have sen-ior citizens suffer because they cannot afford medicine and the other economist might argue It is not fair to have children suffer because their parents cannot afford medicine.

Topic: Positive and Normative Skill: Recognition 24) The difference between positive and normative

statements is that a positive statement is always true while a normative statement might or might not be true. True or false? Explain.

Answer: False. The difference between positive and normative statements is that a positive statement is about what is, while a normative statement is about what ought to be. A positive statement can be tested against the facts and may be proved to be right or wrong, whereas a normative statement depends on values and cannot be tested.

Topic: Positive and Normative Skill: Conceptual 25) Two economists can agree that raising the mini-

mum wage creates unemployment yet one might argue that raising the minimum wage is a good policy and the other that it is a bad policy. Why can this difference exist? Be sure to use the terms positive and normative in your answer.

Answer: Positive statements are statements that de-scribe how the world is. Positive statements can be tested and so, ultimately, any disagreements about positive statements should be resolved. The statement that Raising the minimum wage cre-

W H A T I S E C O N O M I C S ?

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ates unemployment is a positive statement and, on the basis of repeated testing, most economists agree that it is a correct positive statement. Nor-mative statements, however, are statements that describe how the world ought to be. Normative statements depend on peoples values and cannot be tested. So one economist might argue that rais-ing the minimum wage is a good policy because this economist thinks that, although it is unfortu-nate that some people lose their jobs, the fact that others retain their jobs and their wages rise more than outweighs the harm created by the unem-ployment. Another economist might strongly dif-fer because the second economist thinks that the harm inflicted on people who lose their jobs more than outweighs any good from some workers be-ing paid more. This difference of opinion can last indefinitely because there is no way to test the two economists beliefs to determine which is correct.

Topic: Positive and Normative Skill: Conceptual 26) What is a positive statement? Give an example. Answer: A positive statement addresses what is and

can be tested. An example of a positive statement is An increase in the price of gas decreases the quantity of gas demanded.

Topic: Positive and Normative Skill: Conceptual 27) Explain whether the statement, There is life on

Mars, is a normative or positive statement. Answer: The statement is a positive statement be-

cause it does not depend on a value judgment. In-stead, it is a statement that tries to describe what is and hence is testable. Of course, in order to test the assertion, it would be necessary to go to Mars to ascertain if there is life present. While it is difficult (!) at present to actually carry out the test, nonetheless the statement is testable and hence is a positive statement.

Topic: Positive and Normative Skill: Conceptual 28) Explain whether the statement, Hillary Clinton

was elected President of the United States in 2000, is a normative or positive statement.

Answer: The statement is a positive statement be-cause it does not depend on a value judgment. In-stead, it is a statement that tries to describe what is and hence is testable. Now, it is indeed the

case that Hillary Clinton was not elected presi-dent in 2000, so when we test the statement we discover that it is incorrect. But, whether the statement is correct or not has no bearing on whether the statement is positive or normative. Thus, the statement Hillary Clinton was elected President in 2000 is a positive, albeit incorrect, statement.

Topic: Positive and Normative Skill: Conceptual 29) What is a normative statement? Give an example. Answer: A normative statement is a statement about

what ought to be. It is a value judgment or opin-ion and so cannot be proven true or false. An ex-ample of a normative statement is Students should attend school year round to receive a bet-ter education.

Topic: Positive and Normative Skill: Conceptual 30) Explain whether the statement The government

should increase tariffs on Japanese cars to protect the American car industry from competition, is a normative or positive statement.

Answer: The statement is normative. The statement is a normative statement because it depends on a value judgment, namely that the government should protect the American car industry from competition.

Topic: Economic Science Skill: Recognition 31) List the three tasks of economic science. Briefly

explain each. Answer: The three tasks are observing and measuring,

model building, and testing. These tasks involve: Observing and measuring economists must

collect data on the different topics they study. These data measure a variety of activities includ-ing the number of hours worked, the level of in-terest rates, output of specific firms or an entire economy, and so on.

Model building economists simplify reality by describing the economic world using models. Models can be verbal, use mathematics, or be graphical in nature.

Testing economists test the models they for-mulate to see how closely their descriptions of reality mimic actually match it. If the models

6 C H A P T E R 1

perform well repeatedly, they form the basis for an economic theory.

Topic: Models Skill: Conceptual 32) Why is it necessary for models to simplify reality? Answer: The real world is incredibly complex. How-

ever, most of the complexity concerns relatively trivial details that do not affect how events func-tion. For instance, an economic model of driving an automobile might focus on the engine, the transmission, the tires, the brakes, and the steer-ing mechanism while assuming the absence of a radio, an air conditioner, a heater, the back seats, the doors, and so forth. The point is that an automobile will function without the unessential components that are ignored and, if they were in-cluded, the key factors that actually make the car run might well be lost to our vision in a morass of detail. In order to better understand the factors that actually enable an automobile to run, a model of an automobile simplifies the real auto-mobile by ignoring nonessential details.

Topic: Economics: A Social Science Skill: Conceptual 33) What does ceteris paribus mean and why do

economists use it? Answer: Ceteris paribus is Latin for other things be-

ing equal or if all other relevant things remain the same. Economists use the ceteris paribus as-sumption because in the real world most eco-nomic variables are influenced by more than one other variable. By invoking the ceteris paribus as-sumption, economists can focus on the effect of any one variable by itself and thereby gain a better understanding of the impact of each variable.

Topic: Economics: A Social Science Skill: Conceptual 34) What is the importance of the ceteris paribus as-

sumption? Answer: As a social science, economics is concerned

with how societies deal with the issue of scarcity. In order to simplify the world and focus on a par-ticular aspect, economists try to isolate the ramifi-cations of making a small change in only the fac-tor of interest.

Topic: Post Hoc Fallacy Skill: Recognition 35) What is the post hoc fallacy? Give an example of

the post hoc fallacy. Answer: The post hoc fallacy is an error in reasoning

that confuses correlation with causation. The post hoc fallacy occurs when someone reasons that be-cause one event occurred before a second event, the first event caused the second. While it is often the case that an event occurs first and thereby causes a second event, this reasoning is not always correct. For instance, on the way to take this exam, you might have found and picked a four-leaf clover or your path might have been crossed by a black cat. But, if you earn a high score on this exam, very few people would make the post hoc fallacy of attributing the high score to the (al-leged) good luck from the four-leaf clover even though picking the clover occurred before you took the test. Similarly, if you receive a poor score on this exam, few would attribute the low score to the (alleged) bad luck from the black cat, even though the cat crossed your path before you took the exam.

APPENDIX 1 GRAPHS IN ECONOMICS Topic: Graphing Data Skill: Recognition 1) Why do economists use graphs? Answer: Graphs help economists, and others, to visu-

alize the relationships between economic vari-ables. Graphs that plot variables together help economists understand if the variables are related and how they are related. Graphs also help pro-vide a visual picture of economic models that link different variables. Indeed, many other disciplines use such visual models. For example, architects work with blueprints (their model) and the blue-prints represent every detail of a building. Economists models do not reflect of every detail of the real world, but the graphs that they use nonetheless are valuable because they help clarify the linkages between the variables.

Topic: Graphs Skill: Recognition 2) What are three main kinds of graphs? Answer: The three main types of graphs are scatter

diagram, time-series graph, and cross-section dia-gram.

Topic: Time Series Skill: Recognition 3) What kind of information is conveyed in a time-

series graph? Answer: A time series graph reveals four types of in-

formation. First, it shows the actual value of the variable(s) at each point in time. Second, it shows whether the variable(s) is rising or falling as time passes. Third, it shows the speed with which the variable(s) is changing. Finally, it shows the pres-enceor absenceof a trend.

Topic: Relationships Skill: Recognition 4) What are the two different types of relationships

that variables can have? Explain each. What do

these relationships look like when they are graphed?

Answer: Variables can have two relationships: positive (or direct) and negative (or inverse). A positive re-lationship occurs when the variables move in the same direction, so that when one increases, the other also increases. A negative relationship occurs when the variables move in the opposite direc-tion, so that when one increases, the other de-creases. When a positive relationship is graphed, the line slopes upward to the right. When a nega-tive relationship is graphed, the line slopes down-ward to the right.

Topic: Relationships Skill: Recognition 5) What is the difference between a positive and a

negative relationship? Answer: Two variables are positively related when an

increase (decrease) in one is associated with an in-crease (decrease) in the other. In this case, the variables move together, in the same direction. Two variables are negatively related when an in-crease (decrease) in one is associated with a de-crease (increase) in the other. In this case, the variables move in the opposite direction.

Topic: Unrelated Variables Skill: Recognition 6) A graph of two variables is a vertical line. What is

the interpretation of this result? Answer: When the graph of two variables is a vertical

line, the variables are not related because, with this graph, whenever the variable measured along the vertical axis changes, the variable measured along the horizontal axis does not change.

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Topic: Slope Skill: Recognition 7) What does the slope of a straight line equal? How

is the slope of a curved line calculated? Answer: The slope of a straight line is calculated be-

tween two points on the line. Between the two points on the line, the slope equals the change in the value of the variable measured on the vertical axis (the y-axis) divided by the change in the value of the variable measured on the horizontal axis (the x-axis). The slope of a curved line is calcu-lated at a point on the line. At that point on the curved line, draw a straight line that touches the curved line at only that point. Then, calculate the slope of the straight line. The slope of the curved line at that point equals the slope of the straight line.

Topic: Relationships Among More Than Two Variables Skill: Recognition 8) It is impossible to represent a three variable rela-

tionship in a two-dimensional graph. Is this statement true or false? Explain your answer.

Answer: The statement is false because it is possible to represent a three variable relationship in a two dimensional graph. To do so, start by focusing on two of the variables. Assume that the third vari-able does not change (the ceteris paribus assump-tion) and then graph the relationship between the two variables. The graph shows how these two variables are related when the third variable does not change. When the third variable does change, then the entire relationship between the two graphed variables changes. In other words, the line showing the relationship between the two graphed variables shifts so that it becomes an en-tirely new line. The shift in the line shows how the third variable influences the other two.

CHAPTER 2 THE ECONOMIC PROBLEM Topic: Production Possibilities Frontier Skill: Recognition 1) A production point beyond the production possi-

bilities frontier represents what? Answer: A production point beyond the production

possibilities frontier is an unattainable combina-tion of goods and services.

Topic: Production Possibilities Frontier Skill: Recognition 2) Explain how the production possibilities frontier

illustrates scarcity. Answer: The PPF illustrates scarcity because we cannot attain the points outside the frontier.

Topic: Production Possibilities Frontier Skill: Recognition 3) If Mexico is currently operating at a point be-

yond its production possibilities frontier, then there are unemployed resources in Mexico. Is this statement true or false? Briefly explain your answer.

Answer: The statement is false. It is false on two counts. First, production points beyond the pro-duction possibilities frontier are unattainable, so it is not possible for Mexico to be producing at such a point. Second, points within not beyond the production possibilities frontier have unemployed resources.

Topic: Production Possibilities Frontier Skill: Recognition 4) If Mexico is currently operating at a point inside

its production possibilities frontier, then there are unemployed resources in Mexico. Is this state-ment true or false? Briefly explain your answer.

Answer: The statement is true. Points within the pro-duction possibilities frontier are attainable, so it is possible for Mexico to be producing at a point within its frontier. At points within the produc-tion possibilities frontier, there are unemployed resources.

Topic: Production Possibilities Frontier Skill: Recognition 5) Are all points inside the production possibilities

frontier unattainable? Answer: No, all points within the production possi-

bilities frontier are attainable, though there are unemployed resources at these points.

Topic: Production Possibilities Frontier Skill: Conceptual 6) A Russian economist says: There was no unem-

ployment in the former Soviet Union, but I be-lieve the Soviet economy produced below its PPF. How could this statement be correct?

Answer: An economy can produce at a point within its PPF for two reasons: (1) unemployment; (2) mis-allocated resources. So even if there was no un-employment in the Soviet economy, it still could be below its PPF because if resources are not as-signed to tasks for which they would be the best match.

Topic: Production Possibilities and Tradeoffs Skill: Conceptual 7) In the movie Cast Away, Tom Hanks plays a

FedEx efficiency expert stranded on a deserted is-land. While on the island, he divides his time be-tween catching fish, gathering coconuts, painting, and building a raft. Suppose that these were Mr. Hanks only activities. Did he face an opportunity cost from pursuing any of these activities? Why or why not?

Answer: Yes, Mr. Hanks faces an opportunity cost from all of these endeavors. If he decides to use his time catching fish, he cannot gather coconuts, paint, or build a raft. Whatever he would have been doing, not opting to catch fish is his oppor-tunity cost of catching fish. Similarly, time spent on building his raft means less time painting, or fewer coconuts for breakfast, or fewer fish for dinner.

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Topic: Production Possibilities and Opportunity Costs Skill: Conceptual 8) Explain the connection between opportunity cost

and the PPF. Answer: When moving along the production possibili-

ties frontier, more of one good or service can be obtained only by giving up another good or ser-vice. The good or service given up is the opportu-nity cost of the good or service obtained.

Topic: Production Possibilities Frontier Skill: Conceptual 9) Explain why the production possibilities frontier

bows outward. Answer: The bowed outward PPF reflects increasing

opportunity costs. The opportunity cost increases as we produce more of a good because resources are not equally productive in all activities. For ex-ample, people with several years of experience working for Sony are good at producing CDs, but not very good at making pizza. So if we want more pizza and move some of these workers from Sony to Dominos, we get a relatively large de-crease in the quantity of CDs per one additional pizza produced. Of course, first we try to move those workers who have less experience with Sony and who may have some skills to produce pizza. But if we want to produce even more pizza, we eventually will have to move some more experi-enced Sony workers to Dominos, where they might be very unproductive and therefore the quantity of CDs that we will give up to produce an additional pizza, which is the opportunity cost of producing pizza, will increase.

Topic: Production Possibilities Frontier Skill: Conceptual 10) How can a combination of goods be unattainable? Answer: A combination of goods can be unattainable

if producing that combination requires more re-sources and technology than are available. These combinations of goods lie beyond the production possibilities frontier.

Topic: Production Possibilities Frontier Skill: Conceptual 11) What economic concepts are represented in the

production possibilities model? Answer: There are a large number of economic con-

cepts illustrated by the production possibilities frontier: Scarcity of resources: The production possi-

bilities frontier is a frontier between attainable and unattainable combinations.

Opportunity cost: The negative slope of the production possibilities frontier indicates that in order to get more of one good, you must produce less of the other (a tradeoff).

Increasing opportunity cost: The bowed out production possibilities frontier represents the increasing opportunity cost when more of a good or service is produced.

Efficiency: Points on the production possibili-ties frontier use all resources while points be-low the production possibilities frontier repre-sent unemployment.

Topic: Increasing Opportunity Cost Skill: Conceptual 12) Moving on a bowed out PPF, what happens to

the opportunity cost of a good as more of it is produced?

Answer: The bowed out PPF indicates that as the amount of the good produced increases, the goods opportunity cost increases.

Topic: Increasing Opportunity Cost Skill: Conceptual 13) Why is the production possibilities frontier

bowed out? Answer: The production possibilities frontier is bowed

out because resources are not equally productive in all uses. The resources used to produce robots are different from the resources used to produce pizzas. Thus, as more of one good is produced, say robots, less productive resources must be used to increase the number of robots produced. Hence the opportunity cost of the additional ro-bots increases, which gives the production possi-bilities frontier a bowed out shape.

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Topic: Increasing Opportunity Cost Skill: Conceptual 14) When does the production possibilities frontier

have a bowed out shape rather than be a straight line?

Answer: If as the production of one good or service increases, its opportunity cost increases means that the production possibilities frontier will be bowed out. Only if the opportunity cost remains constant as the production of a good increases is the production possibilities frontier a straight line.

Topic: Increasing Opportunity Cost Skill: Conceptual 15) When economists state that the opportunity cost

of a product increases as more of it is produced, what do they mean? What is the opportunity cost?

Answer: In general, the opportunity cost of increasing the production of one good or service is the for-gone production of another good or service. The statement that the opportunity cost of a product increases as more of it is produced applies to pro-duction points on the production possibilities frontier. On the production possibilities frontier, resources are fully employed. Hence to increase the production of one good or service, resources must be switched away from the production of another good or service and hence the production of that good or service decreases. And, as more of the first good or service is produced, the opportu-nity cost of an additional unit becomes larger, so that the opportunity cost increases.

Topic: Increasing Opportunity Cost Skill: Conceptual 16) What is the relationship between the bowed out

shape of the production possibilities frontier and the increasing opportunity cost of a good as more of it is produced?

Answer: The production possibilities frontier is bowed out because the opportunity cost of a good in-creases as more of it is produced. As the first unit of the good measured along the horizontal axis is produced, resources that are extremely well suited for its production can be used. Because of the suitability, not many resources need to be devoted to its production, so the opportunity costthe decrease in the production of the good measured along the vertical axisis not large. At this loca-

tion along the production possibilities frontier, the slope of the production possibilities frontier is shallow. But, as more of the product is produced, resources that are not as well suited must be de-voted to its production. Consider one of the last units of this good, just before the production pos-sibilities frontier intersects the horizontal axis. By the time the nation produces this much of the product, to produce one more unit means that re-sources that are extremely poorly suited in its manufacture must be used. Because these re-sources are not well suited, a lot of them must be used and, because a lot of them must be used, the opportunity cost in terms of the forgone other good is large. With the large decrease in the pro-duction of the good along the vertical axis, the slope of the production possibilities frontier at this location is steep. So, the production possibili-ties frontier goes from having a shallow slope to a steep one, that is, the production possibilities frontier is bowed outward.

Topic: Marginal Benefit Skill: Recognition 17) Why does the marginal benefit curve have a nega-

tive slope? Answer: Each successive increase in the consumption

of any good or service provides a lower level of satisfaction, or benefit, than the preceding unit of consumption. For a specific example, think of drinking water on a hot day. What is the first glass worth? How about the second and third? The marginal benefit is the benefit from each ad-ditional glass of water and, as the example indi-cates, the marginal benefit decreases as the amount of the good increases.

Topic: Marginal Cost and Marginal Benefit Skill: Conceptual 18) Explain the difference between marginal cost and

marginal benefit. Answer: Marginal benefit is the benefit someone in

society obtains when another unit of a good or service is produced. Marginal cost is the cost to someone in society of producing another unit of a good or service.

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Topic: Efficient Use of Resources Skill: Conceptual 19) Compare and contrast production and allocative

efficiency. Answer: Production efficiency means that we are

operating at a point on the production possibili-ties frontier and so we cannot produce more of a good or service without producing less of some other good or service. Production efficiency oc-curs at all points on the PPF. At any point inside the frontier, production is inefficient because we have unemployed resources. Allocative efficiency means that we are producing the goods and services that society values most highly and so allocative efficiency implies that we are operating on the frontier. But not every point on the production possibilities frontier is the combination of goods and services valued most highly by society. Allocative efficiency only occurs at a single point on the PPF. To insure that allo-cative efficiency exists, we must compare the mar-ginal benefit of a good with its marginal cost. When production is such that the marginal bene-fit equals the marginal cost, then we are produc-ing the allocatively efficient level of output.

Topic: Allocative Efficiency Skill: Conceptual 20) Allocative efficiency in the production of cherries

means that consumers can eat all of the cherries they desire. Is this statement true or false?

Answer: Allocative efficiency means that we are pro-ducing the goods and services society values most highly. It does not mean that consumers can af-ford all of the cherries that they desire. The alloca-tively efficient quantity of cherries is the level of production such that the marginal benefit of a pound of cherries equals the marginal cost of a pound of cherries. The marginal cost of any prod-uct will be positive, so the marginal cost of a pound of cherries at the allocatively efficient quantity will be positive. Hence for the alloca-tively efficient quantity of cherries, the marginal benefit of cherries also must be positive. In order for consumers to have all the cherries they desire, the marginal benefit of a pound of cherries must be zero. (If the marginal benefit is positive, con-sumers desire more cherries.) Therefore the alloca-tively efficient quantity of cherries is not the

quantity at which consumers are able to eat all they desire.

Topic: Allocative Efficiency Skill: Conceptual 21) If an economy is producing at a point on its

PPF, it has achieved allocative efficiency. True or false? Explain.

Answer: If an economy is producing at a point on its PPF, it has achieved production efficiency, but not necessarily allocative efficiency. We have achieved allocative efficiency if we are producing at the point on the PPF that we prefer to all other points because at this point we cannot produce more of any good without giving up some other good that we value more highly.

Topic: Allocative Efficiency Skill: Conceptual 22) Allocative efficiency requires that the maximum

number of people have access to all of the goods and services that our economy produces. Is this statement true or false? Explain your answer.

Answer: The statement is false. Allocative efficiency requires that production be such that the marginal benefit equals the marginal cost. Allocative effi-ciency has nothing to do with requiring that the maximum number of people have access to all the goods and services produced.

Topic: Economic Growth Skill: Recognition 23) What factors generate economic growth? Answer: Two key factors create economic growth:

Technological change and capital accumulation, including the accumulation of additional human capital. Both technological change and capital ac-cumulation shift the nations PPF outward.

Topic: Economic Growth Skill: Conceptual 24) Country X and Country Y are both efficient in

production. Country X devotes one third of its re-sources to accumulating capital and the other three fourth to consumption. Country Y devotes one fourth of its resources to accumulating capital and two thirds to consumption. Which country will grow faster? In which country the opportu-nity cost of economic growth is higher? Explain.

Answer: Country X will grow faster because it devotes a greater fraction of its resources to accumulating

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capital. As a result, Country X will have more productive resources in the future, which will al-low it to expand its production possibilities more quickly, so its economy will grow faster. But the opportunity cost of economic growth is also higher in Country X. This country sacrifices a greater fraction of current consumption to pro-duce more capital.

Topic: Comparative Advantage Skill: Conceptual 25) What is comparative advantage? Give an example. Answer: Comparative advantage is the ability of a per-

son to produce a good at a lower opportunity cost compared to another person. A lower opportunity cost means that the person gives up less to pro-duce the good compared to another person. For example, one person may need to give up one hour of typing to get dinner made while another person must give up two hours of typing to pro-duce the same dinner.

Topic: Comparative Advantage and Absolute Advantage Skill: Conceptual 26) When a person has an absolute advantage in

producing a good, the person necessarily has a lower opportunity cost of producing it. Is this as-sertion true or false?

Answer: The assertion is incorrect. An absolute advan-tage is when a person can produce more of the good than someone else. A comparative advantage relies on a comparison of opportunity costs, so a person has a comparative advantage in producing a good if the person can produce the good at a lower opportunity cost.

Topic: Comparative Advantage and Absolute Advantage Skill: Recognition 27) When a person can produce more of a good or

service than another person, the first person has the comparative advantage in producing the good. Is this assertion correct or incorrect? Ex-plain your answer.

Answer: The assertion is incorrect. The statement de-scribes an absolute advantage, that is, a person has an absolute advantage in the production of a good if the person can produce more of it than some-one else. Comparative advantage, however, relies on a comparison of opportunity costs. A person

has a comparative advantage in producing a good if the person can produce the good at a lower op-portunity cost than another person.

Topic: Comparative Advantage and Absolute Advantage Skill: Conceptual 28) Why is it likely that the United States has an ab-

solute advantage in goods and yet it still ends up importing them from other countries?

Answer: The United States might have an absolute advantage in producing a good but not a com-parative advantage. In this case, the opportunity cost of producing the good in the United States is higher than in another country. Thus the United States will import the product from the other country.

Topic: Comparative Advantage and Absolute Advantage Skill: Conceptual 29) The United States has an absolute advantage in

producing sugar over all of the other sugar pro-ducing countries. Does this fact mean that we should not import any sugar from the other coun-tries?

Answer: Having an absolute advantage doesnt mean that the United States should engage in the pro-duction of sugar. If the opportunity cost of sugar in the United States is higher than in the other countries, then the other countries will have the comparative advantage. The countries with the comparative advantage are the ones that should do the producing. Quite likely these other nations have the comparative advantage and so it would be good policy for the United States to import sugar from these nations.

Topic: Comparative Advantage and Absolute Advantage Skill: Conceptual 30) If the United States has an absolute advantage in

the production of wheat, it should specialize in wheat and export wheat. True or false? Explain.

Answer: Whether or not the United States should specialize in the production of wheat and export wheat depends on whether or not it has a com-parative advantage in producing wheat. The fact that the United States has an absolute advantage in wheat does not necessarily mean that it also has a comparative advantage in this product.

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Topic: Dynamic Comparative Advantage Skill: Recognition 31) What is a dynamic comparative advantage? What

generates it? What are some examples of nations that have used this type of comparative advantage?

Answer: A dynamic comparative advantage is gener-ated by learning-by-doing. As a nation trains its labor force to produce a good or service, initially the nation might not have a comparative advan-tage in producing the good or service. But if there is learning-by-doing, as more of the good or ser-vice is produced, the workers learn how to pro-duce it at a lower opportunity cost. Eventually the opportunity cost falls enough so that the nation winds up possessing a comparative advantage in the production of the good or service. Hong Kong, South Korea, and Taiwan are countries that have pursued and gained dynamic compara-tive advantages, particularly in electronics and biotechnology.

Topic: Gains from Trade Skill: Recognition 32) What is the difference between comparative ad-

vantage and absolute advantage? Answer: A person has a comparative advantage if he or

she can produce a good or service at lower oppor-tunity cost than anyone else. In other words, for this person to produce a good or service, fewer other goods or services must be given up. A per-son has an absolute advantage if he or she can produce more of a good or service in a given time period than anyone else. Absolute advantage does not indicate the (opportunity) cost of producing the particular good or service.

Topic: Gains from Trade Skill: Conceptual 33) Why does it make sense for economies to special-

ize according to comparative advantage and trade? Answer: A person has a comparative advantage in an

activity that they can perform at a lower opportu-nity cost than other people. By participating in the activity in which they have a comparative ad-vantage, less is given up. Because resources are scarce, more can be produced with available re-sources when less is given up. And, by trading

people can consume more than just what they produce.

Topic: Gains from Trade Skill: Conceptual 34) The United States is more productive in most

activities than are most of other countries because it has an absolute advantage in the production of most goods and services. Therefore we should re-strict international trade as it only benefits other countries at the expense of the United States. Comment on this statement.

Answer: The United States may be more productive than other countries in producing most goods and services so that it has an absolute advantage in most products, but it sill has a comparative disad-vantage in many goods and services. Thus the United States and can gain from buying these goods and services from other countries and sell-ing to these other countries the goods and services in which the United States has a comparative ad-vantage to them. For example, the United States can have an absolute advantage over China in producing both cars and grain, but if China has a comparative advantage in grain, it can produce grain with a lower opportunity cost, that is, fewer cars given up to get a thousand tons of grain, than can the United States. In this case, the United States can benefit by importing Chinese grain and paying for it with fewer cars then the United States would have to give up if the same amount of grain was produced domestically.

Topic: The Market Economy Skill: Conceptual 35) How do property rights help organize production

and trade? Answer: Property rights are necessary in order for peo-

ple to specialize. If people specialize in produc-tion, they will want to consume more than just what they produce. Without property rights, peo-ple would worry that someone else would take their production, leaving them with little or noth-ing to trade for the other goods and services they want to consume.

CHAPTER 3 DEMAND AND SUPPLY Topic: Price and Opportunity Cost Skill: Conceptual 1) Explain why a relative price is an opportunity

cost. Answer: A relative price is the ratio of the price of one

good or service to the price of another good or service. It tells us how much of one good or ser-vice must be given up in order to obtain more of the other good.

Topic: Price and Opportunity Cost Skill: Conceptual 2) What is the difference between a money price and

a relative price? When the demand and supply model predicts that the price of coffee will rise, is the model predicting that the money price rises or the relative price rises?

Answer: The money price of a good is the number of dollars that must be given up in exchange for it. A relative price is the opportunity cost of a good in terms of another good. A relative price of good X is the quantity good Y that we forgo to get a unit of good X. When the supply-and-demand model predicts that the price of coffee will rise, it is the relative price, that is the model predicts that the price of coffee will rise relative to the average price of other goods. The money price might or might not rise.

Topic: Law of Demand Skill: Recognition 3) What is the law of demand? Answer: The law of demand states that other things

remaining the same, if the price of a good rises, the quantity demanded of that good decreases, and if the price of a good falls, the quantity de-manded of that good increases.

Topic: Law of Demand Skill: Recognition 4) What leads to a decrease in the quantity de-

manded of a good or service? Answer: The quantity demanded of a good or service

decreases when the price of the product increases.

Topic: Demand Curve Skill: Conceptual 5) An economist says: The demand curve has two

interpretations. What does the economist mean? Answer: The first interpretation is that the demand

curve shows the quantities of a good or service that consumers are willing and able to buy at each price, other things being equal. The second inter-pretation is that the demand curve is a willing-ness-and-ability-to-pay curve, so that for each quantity it shows the highest price that someone is willing and able to pay for one more unit.

Topic: Change in Demand Skill: Recognition 6) List the factors change demand and shift the de-

mand curve. Tell what happens to demand and the demand curve when there is an increase in the factor.

Answer: One factor that changes demand is a change in income. An increase in income increases de-mand and shifts the demand curve rightward for a normal good. An increase in income decreases demand and shifts the demand curve leftward for an inferior good. A change in the price of a substi-tute or complement also changes demand. An in-crease in the price of a substitute increase demand and shifts the demand curve rightward while an increase in the price of a complement decreases demand and shifts the demand curve leftward. Expectations, the population, and preferences also change demand. If people expect their income to increase, or if they expect the price of the good to be higher in the future, or if the population in-

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creases (so that the number of buyers increases), or if peoples preferences for the good increase, demand increases and the demand curve shifts rightward.

Topic: Change in Demand, Prices of Related Goods Skill: Analytical 7) Computers are a complement to computer soft-

ware. Suppose the price of a computer falls. How does this fall in price affect the demand for com-puter software and the demand curve for com-puter software?

Answer: The fall in the price of a complement in-creases the demand for a product. Hence the fall in the price of a computer increases the demand for computer software and shifts the demand curve for computer software rightward.

Topic: Change in Demand, Income Skill: Recognition 8) What is the difference between a normal good

and an inferior good? Give an example of each. Answer: A good is a normal good if an increase in

incomes leads to an increase in demand for a good. Most goods are normal goods. An example of a normal good is new clothes. A good is an in-ferior good if an increase in income leads to a de-crease in demand for the good. Second-hand clothing that can be purchased at thrift stores is an inferior good.

Topic: Change in Demand, Income Skill: Recognition 9) Consumers income declines and, as a result, the

demand for margarine increases. Is margarine a normal or an inferior good? Explain.

Answer: Margarine is an inferior good. An inferior good is one for which demand increases as income decreases, which describes the situation outlined for margarine in the question.

Topic: A Change in the Quantity Demanded Versus a Change in Demand Skill: Recognition 10) Explain the difference between a change in de-

mand and a change in quantity demanded. What leads to each of these changes?

Answer: A change in demand occurs when consumers will buy more or less of a product at every price; a change in the quantity demanded occurs when the price changes and consumers buy more or

less. A change in demand is reflected by a shift of the entire demand curve, while a change in the quantity demanded is reflected by a movement along one demand curve.

Only a change in the price of the good brings about a change in the quantity demanded. A change in demand is brought about by a change in any of the other influences on demand, namely, the prices of related goods, income, ex-pectations, the number of buyers, and prefer-ences.

Topic: A Change in the Quantity Demanded Versus a Change in Demand Skill: Conceptual 11) Your friend Tony opened a pizzeria. You helped

him to advertise his pizza, which is in fact the best pizza in town. As a result, the demand for Tonys pizza increases and your friend, noticing lines of customers, raises the price of his pizza. But then he fears that the higher price will cause demand to decline, which will cause the price to drop. Is Tony right in his analysis of the situation? Ex-plain.

Answer: Tony is confusing a change in demand (a shift of the demand curve) with a change in quan-tity demanded (a movement along the demand curve). An increase in the price of his pizza cannot cause the demand for his pizza to decline, that is, it cannot shift the demand curve for his pizza leftward.. The rise in the price results in a decrease in the quantity of pizza demanded. So Tony need not fear that the demand for his pizza will de-crease as a result of a higher price.

Topic: Demand Curve Skill: Conceptual 12) An economist says: The supply curve has two

interpretations. What does the economist mean? Answer: The first interpretation is that the sup-ply curve shows the quantities of a good or service that producers are willing and able to sell at each price, other things being equal. The second inter-pretation is that the supply curve is a minimum-supply-price curve, so that for each quantity it shows the lowest price at which someone is willing to sell another unit.

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Topic: Change in Supply Skill: Recognition 13) List the factors that change supply and shift the

supply curve. Tell what happens to supply and the supply curve when there is an increase in the factor.

Answer: The factors that change supply are technol-ogy, the number of sellers, expected future prices, prices of resources and prices of related goods. An advance in technology, an increase in the price of a complement in production, an increase in ex-pected prices, and an increase in the number of sellers all lead to an increase in supply and a rightward shift in the supply curve. An increase in the price of a substitute in production or an in-crease in the prices of resources leads to a decrease in supply and a leftward shift in the supply curve.

Topic: Change in Supply, Prices of Related Goods Produced Skill: Recognition 14) What are substitutes in production? Answer: Goods are substitutes in production when

one good can be produced in place of the other, that is, when the goods are produced using the same resources.

Topic: Change in Supply, Number of Suppliers Skill: Conceptual 15) Suppose that the number of companies selling

computer software decreases. How does this change affect the supply of computer software and the supply curve of computer software?

Answer: A decrease in the number of sellers decreases the supply. Hence the decrease in the number of companies selling computer software decreases the supply of computer software and shifts the supply curve of computer software leftward.

Topic: Change in Supply, Technology Skill: Conceptual 16) Suppose that the technology used to produce

computers advances. How does this change affect the supply of computers and the supply curve of computers?

Answer: An advance in technology increases the sup-ply of computers. Hence increases in technology shift the supply curve of computers rightward.

Topic: A Change in the Quantity Supplied Versus a Change in Supply Skill: Recognition 17) What leads to a decrease in the quantity supplied

of a good or service? Answer: The quantity supplied of a good or service

decreases when the price of the product decreases.

Topic: A Change in the Quantity Supplied Versus a Change in Supply Skill: Recognition 18) What is the difference between quantity supplied

and supply? Answer: Quantity supplied is the amount that people

are willing to sell during a specific period for a specific price. It deals with one quantity at one price. Supply is the relationship between the quantity supplied and the price of the good. Sup-ply applies to various prices and various quanti-ties.

Topic: Price Adjustment; Surplus Skill: Conceptual 19) Explain how price can be a regulator, that is, how

it can coordinate the plans of buyers and sellers. Answer: If the price is too high, the quantity supplied

exceeds the quantity demanded so there is a sur-plus. The surplus forces the price lower. The lower price increases the quantity demanded and decreases the quantity supplied bringing the mar-ket to equilibrium, where the quantity demanded equals the quantity supplied and where the plans of buyers and sellers are coordinated. If the price is too low, the quantity demanded exceeds the quantity supplied so there is a shortage. The shortage forces the price higher. The higher price decreases the quantity demanded and increases the quantity supplied bringing the market to equilibrium, again coordinating the plans of buy-ers and sellers.

Topic: Price Adjustment; Shortage Skill: Recognition 20) When does a shortage occur? Answer: A shortage occurs when the price is below

the equilibrium price. When the price is less than the equilibrium price, the quantity demanded is greater than the quantity supplied.

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Topic: Price Adjustment; Surplus Skill: Recognition 21) When does a surplus occur? Answer: A surplus occurs when the price is above the

equilibrium price. When the price exceeds the equilibrium price, the quantity supplied is greater than the quantity demanded.

Topic: Price Adjustment; Shortage Skill: Recognition 22) At prices above the equilibrium price, what oc-

curs? Answer: If the price exceeds the equilibrium price,

there is a surplus because the quantity supplied exceeds the quantity demanded. With a surplus, the law of markets points out that the price will fall. As the price falls, the quantity supplied de-creases and the quantity demanded increases, thus decreasing the size of the surplus. The price will continue to fall as long as there is a surplus, that is, as long as the price exceeds the equilibrium price. Ultimately the price will fall to equal the equilibrium price, at which time the surplus will be eliminated and the price will no longer change.

Topic: Predicting Changes in Price and Quantity; Demand Changes Skill: Analytical 23) When the demand for blue jeans increases, what

happens next? Answer: If the demand for blue jeans increases, then

at all prices buyers are more willing and more able to buy blue jeans. The demand curve for blue jeans shifts rightward. With the curve shifts, at the initial price a shortage of jeans will emerge. The law of supply and demand will force the price higher. Hence an increase in demand for blue jeans leads to a rise in the price of a pair of blue jeans and an increase in the quantity of blue jeans.

Topic: Predicting Changes in Price and Quantity; Supply Changes Skill: Analytical 24) Why does an increase in the supply of computers

lead to a lower price for a computer? Answer: When the supply of a good, such as com-

puters, increases, the supply curve shifts right-ward. This shift means sellers are more willing and more able to sell computers at all prices than they were before. With this change, a surplus of computers results. The surplus forces the price to

fall, which, when the price falls enough, elimi-nates the surplus.

Topic: Predicting Changes in Price and Quantity; Supply Changes Skill: Analytical 25) If the price of crude oil falls, the demand for

gasoline will increase, so people will by more gas and the price of gas will go up. Is this statement true or false? Explain.

Answer: The analysis is false. If the price of crude oil falls, the supply of gasoline increases, because crude oil is a resource used to produce gasoline. The prices of resources used to produce the good influence its supply, not demand. So, if the price of oil falls, the supply of gasoline increases and the supply curve shifts rightward. The equilibrium price of gasoline falls. It is true that people will buy more gasoline, but this happens not because the demand increases, but because a lower price results in a movement down the demand curve so that the quantity demanded increases.

Topic: Predicting Changes in Price and Quantity; Supply Changes Skill: Analytical 26) Personal computers are becoming less expensive as

new technology reduces the cost of production. In a supply and demand model, explain the effects of the technological innovations and their effect on the quantity of computers.

Answer: Advances in technology increase the supply of computers and the supply curve of computers shifts rightward. The price of a computer thus falls. The demand curve does not shift. Rather, on the demand side there is an increase in quantity demanded, or movement along the curve, in re-sponse to the falling price. The equilibrium quan-tity of computers increases.

Topic: Predicting Changes in Price and Quantity; Supply Changes Skill: Analytical 27) In the market for bicycles, explain what happens

to the supply and demand curves when there is an increase in the price of steel used to make bikes.

Answer: An increase in the price of steel is an increase in the price of a resource used to make the good. As a result, the supply of bicycles decreases and the supply curve shifts leftward. There is no change to the demand, so the demand curve does

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not shift. The equilibrium price of a bicycle rises and the equilibrium quantity decreases.

Topic: Predicting Changes in Price and Quantity; Demand/Supply Increase Skill: Analytical 28) What is the effect on the price and quantity of a

product if both the demand and supply simulta-neously increase?

Answer: The equilibrium quantity unambiguously increases. The effect on the equilibrium price is ambiguous. The equilibrium price rises if the in-crease in demand exceeds the increase in supply. The equilibrium price falls if the increase in sup-ply exceeds the increase in demand. The equilib-rium price is unchanged if the increase in demand equals the increase in supply.

Topic: Predicting Changes; Demand Decreases and Supply Increases Skill: Analytical 29) What is the effect on the price and quantity of a

product if the demand decreases and the supply simultaneously increases?

Answer: The equilibrium price unambiguously falls. The effect on the equilibrium quantity is ambigu-ous. The equilibrium quantity decreases if the de-crease in demand exceeds the increase in supply. The equilibrium quantity increases if the increase in supply exceeds the decrease in demand. The equilibrium quantity is unchanged if the decrease in demand equals the increase in supply.

Topic: Predicting Changes; Demand Increases and Supply Decreases Skill: Analytical 30) Computers are a complement to computer soft-

ware. Suppose the price of a computer falls. Si-multaneously, suppose that the number of com-panies selling computer software decreases. How do these changes affect the price and quantity of computer software?

Answer: The fall in the price of a computer increases the demand for computer software and the de-mand curve for computer software shifts right-ward. A decrease in the number of sellers de-creases the supply of computer software and the shifts the supply curve of computer software left-ward. The increase in demand and decrease in supply both raise the price, so the price definitely rises. The increase in demand increases the quan-

tity and the decrease in supply decreases the quan-tity. Hence the net effect on the quantity is am-biguous.

Topic: Predicting Changes; Demand Increases and Supply Decreases Skill: Analytical 31) In early 2003 the price of computer memory

chips rose. In a demand and supply model, shifts in what curve(s) could have brought about the higher price?

Answer: The higher price could have been brought about by an increase in demand, a decrease in supply, or the combination of an increase in de-mand combined with a decrease in supply. Hence the higher price could have been the result of a rightward shift in the demand curve, a leftward shift in the supply curve, or a combined rightward shift of the demand curve and leftward shift of the supply curve.

Topic: Predicting Changes in Price and Quantity Skill: Analytical 32) During the real estate boom of the mid-1990s,

the prices of new and existing homes rose year af-ter year yet people purchased more homes year af-ter year. Can this outcome be explained as an ex-ception to the law of demand?

Answer: No; it is explained by a rightward shift of the demand curves for new and existing homes. The rightward shift was caused by rising consumer in-comes and lower mortgage interest rates.

Topic: Market Equilibrium Skill: Analytical 33) If the equilibrium relative price for a two-liter

bottle of Coca-Cola is $1.50 today, just like it was ten years ago, can we safely say that all supply and demand conditions in the market for Coke have remained very stable all these years?

Answer: Not necessarily. The demand curve might have shifted rightward continuously due to popu-lation growth in the United States and growing demand for Coke in other countries world-wide. Although that alone would have driven up the price, there could have been other factors shifting the supply curve rightward, such as improved technology for producing and transporting Coke, or declining sugar prices because of some great sugar harvests. Regardless of the reason, if the supply increased, so that the supply curve shifted

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rightward, then the increase in supply, which leads to a fall in the equilibrium price, can offset any increase in the demand. So, even if the price has remained constant, the only accurate state-ment is that any change in demand was accompa-

nied by an equal sized change in the supply in the same direction.

CHAPTER 4 ELASTICITY Topic: The Price Elasticity of Demand Skill: Recognition 1) The price elasticity of demand is a measure of

how sensitive demanders are to changes in the price of a product. Is this statement true or false?

Answer: The assertion is true. All elasticities measure the sensitivity, or responsiveness, of some variable to a change in an influence. The price elasticity of demand measures how strongly demanders re-spond to a change in the price of the good or ser-vice.

Topic: The Price Elasticity of Demand Skill: Recognition 2) What is the price elasticity of demand and how is

it measured? Answer: The price elasticity of demand is a unit-free

measure of responsiveness of the quantity de-manded of a good to a change in its price when all other influences on buyers plans remain the same. To calculate the price elasticity of demand we di-vide the percentage change in quantity demanded by the percentage change in price.

Topic: The Price Elasticity of Demand Skill: Recognition 3) What is the price elasticity of demand? In terms

of percentage changes, what is its formula? Answer: The price elasticity of demand is a measure

of the responsiveness of quantity demanded to a change in price. The formula fo

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