Check Yourself Solutions for Chapter 5 through Chapter 8

Chapter 5-1

  1. There are more substitutes for a brand than for a general product category, so there are more substitutes for Dell computers than for computers. When there are more substitutes, demand is more elastic, so demand is more elastic for Dell computers than for computers.

  2. An elasticity of demand of 0.1 is an inelastic demand. With inelastic demand, revenue and price move together. Thus, if the price of eggs increases, total revenue will increase. Bonus points if you said that with an elasticity of 0.1, when price goes up by 10%, quantity goes down by 1%, so revenues (= P × Q) increase by approximately 9%.

  3. A fashionable clothing store might raise its prices by 25% if it thought there was inelastic demand for its products: The increase in price on everything would more than make up for the decrease in sales (quantity).

Chapter 5-2

  1. Supply is usually not very elastic in the short run. In the case of computer chips, a factory can run 24 hours per day and pay overtime, but it takes years to build a new factory. In the long run, supply is more elastic because over time a computer chip firm can respond to increased demand by building new factories.

  2. Manhattan is an island with very little land available for development, so the supply of housing in Manhattan is very inelastic. In contrast, a lot of unbuilt land is available in the Des Moines area, so the supply is more elastic. The same increase in demand will increase the price more when the supply is inelastic than elastic; thus the same increase in demand will increases prices more in Manhattan than in Des Moines.

B-4

Chapter 6-1

  1. Because demand for insulin is highly inelastic, the users of insulin are likely ultimately to pay a government insulin tax. Producers of insulin have some ability to produce other products and so can escape the tax more readily.

  2. The government would rather tax items that have relatively inelastic demands and supplies rather than elastic demands and supplies because the deadweight loss from taxation is lower when supply and demand are inelastic.

  3. The easiest way to show this is to go back to Figure 6.5. In the right panel, draw in an almost inelastic supply curve. Now draw in an almost elastic supply curve. Visually examine the relative differences in consumer surplus and producer surplus. Remember that elasticity = escape so the relatively elastic side escapes and loses less surplus while the relatively inelastic side can’t escape and so loses more surplus.

Chapter 6-2

  1. Because of the ethanol subsidy, the quantity supplied of ethanol increases. The subsidy increases the price received by the ethanol producers (corn growers) and lowers the price paid by ethanol users. The relative amount received by producers vs. that paid by buyers depends on the relative elasticities of demand and supply.

  2. Government subsidies for college education increase the demand for education. The supply of education, however, is relatively inelastic, especially at elite colleges. Thus, the benefits of the subsidy flow to suppliers; that is, the price paid to suppliers increases by more than the price paid by buyers falls. Much of the subsidy ends up raising the incomes of professors! Perhaps this is one reason that many professors argue for subsidies to education.

Chapter 7-1

  1. If farmers receive a higher price for turning corn into ethanol, they will supply more of their corn for ethanol production. Thus, the (opportunity) cost of supplying corn for cornbread will increase and there will be a decrease in the supply of corn for cornbread. As a result, the price of cornbread will increase and customers will consume less, perhaps substituting cheaper items such as regular bread.

  2. During the housing boom, the use of lumber skyrocketed, as did the supply of a lumber by-product, sawdust. The increase in the supply of sawdust caused a fall in the price of sawdust. Since a lot of sawdust is used in bedding milk cows, this reduced the cost of producing milk. When the housing boom collapsed, less lumber was produced so less sawdust was produced and the price of sawdust rose, which increased the cost of producing milk and thus the price of milk. Markets are linked in nonobvious ways. Who would have thought the housing and milk markets were linked so closely?

B-5

Chapter 7-2

  1. We aren’t peanut experts either but the highest value of peanuts is probably in its use as a food; furthermore, there are fewer substitutes for peanuts in paint, varnish, and furniture polish, where the peanut has some unique properties, than in insecticides or soap or finally bird feed. So let’s rank the uses of peanuts from highest to least valued as follows: food, paint, varnish, furniture polish, insecticides, soap, and bird feed. Any ranking you have is fine—the point is that there is a ranking.

  2. If there is a peanut crop failure in a large producer such as China, the price of peanuts and peanut products will rise and people will substitute away from peanuts in their least-valued uses. Thus, we would expect fewer peanuts used in bird feed, soap, and insecticides, which will free up more peanuts for use in the higher-valued categories. Thus, as the price of peanuts rises, there is a reallocation of peanuts from lower- to higher-valued uses. It’s important to recognize that the best way of figuring out which uses are higher valued is to see what happens when the price rises.

Chapter 7-3

  1. No central planner could possibly know or understand all of the links between products so the messaging system is unlikely to send the right information. But let’s suppose that the information problem was solved. Even if the government sent the right messages, there would still be an incentive problem. What incentives would producers and consumers have to obey the messages? In contrast, the price system sums up all of the links between products in one number, the price, and it provides an incentive to pay attention to the price. Thus, the price system solves the information problem and the incentive problem, which is why we say that a price is a signal wrapped up in an incentive.

  2. If firms do not have to face bankruptcy, they can continue with poor products, practices, and efforts. The fear of bankruptcy is a spur to innovate and grow, but the fear has to be backed up by the reality.

Chapter 7-4

In hindsight, it is clear that Lehman Brothers was engaged in wishful thinking. Speculators, with their money on the line, did not believe the Lehman forecasts. Companies can have a tendency to look at things in the best possible way and to ignore reality, and speculators provide a market vote (a reality check).

Chapter 8-1

  1. Price ceilings set below equilibrium prices cause shortages. Price ceilings set above equilibrium prices have no effects.

  2. A price control reduces the incentive to respond to shifts in demand, thus resources become misallocated according to essentially random factors. For example, it costs much more to ship oil from Alaskan oil fields to refineries on the East Coast than on the West Coast. Price ceilings did not let that difference become factored in the price, and therefore reduced the incentive to ship oil to where it was most needed so shortages could be worse in some areas than in others.

B-6

Chapter 8-2

  1. If landlords under rent control have an incentive to do only minimum upkeep, deteriorating buildings inevitably accompany rent control. Only major repairs are made. Tenants with dripping faucets may never get a response from landlords, and have to fix it themselves. At a minimum, they will have to wait, maybe until the drip becomes something larger and so has an effect on the landlord’s water bill.

  2. Vested interests will fight any attempt at rolling back rent control, and these vested interests become powerful over time. It’s especially difficult to eliminate rent controls because tenants (people who already have an apartment) don’t care much about the shortage—they do not have to find a new apartment every week. In contrast, buyers of gasoline have to deal with the shortage every time they need a fillup so it may be easier to get rid of price controls on oil than on apartments.

Chapter 8-3

  1. Price ceilings cause shortages. Universal price controls cause shortages across the economy, with no obvious pattern. Sometimes one product is in abundance, at other times there are shortages. A rational response when there are products that face inexplicable shortages is to buy as much as possible when possible: buy as much toilet paper now because who knows when it will come available again? In other words, hoarding is a standard response to universal price controls. Hoarding is wasteful because it implies a misallocation of resources. Some people, for reasons of luck (or influence), may have a lot of toilet paper while others have none. If trade were allowed, people would experience gains from trade and products would gravitate to their highest-value uses.

  2. The Soviet Union also faced surpluses of goods as well as shortages because under universal price controls there was no incentive to get products to the places at the times that they had the highest-value uses. As a result, goods would be misallocated and production and consumption would be chaotic. One week a farm might get enough oil to deliver its chickens to the city and in that week the city shops would get a lot of chickens as the farm dumped its accumulated stock. A few weeks later there might be no oil available and chickens would disappear from the shops.

Chapter 8-4

  1. A price floor set above the equilibrium price leads to surpluses. Because the European Union price floor for butter is above the equilibrium price, the EU has created a surplus of butter, which the government must buy. The surplus has been so large that it has been called a butter mountain.

    B-7

  2. The U.S. price floor for milk, set above the equilibrium price, has led to a surplus of milk. The government has dealt with the surplus by buying the surplus and giving away milk and dairy products produced from milk (such as cheese) to schools. This accounts for the low or zero price you paid for milk at most schools.