Unit 1: An Introduction to Economics, Efficiency, and the World Economy

Ch. 1 -- The Nature and Method of Economics and the 4 Es

(only pages: 1- 5, 9-12, 14-17, 23-24)

Ch. 2 -- The Economizing Problem: Making Choices

(plus pages 317- 318)

Ch. 3 -- Understanding Individual Markets: Demand and Supply

Ch. 4 -- Pure Capitalism and the Market System: The Market

and the 4 Es

Ch. 20--International Trade: Specialization, Exchange, and Efficiency

(only pages 399-406, 409-410, 411-419; plus pages 441-445)

Ch. 23--Economies in Transition

Suggested Textbook Questions:

Ch. 1: pp. 12-13 1, 2, 3, 4, 5, 13, 14

pp. 19-20 1, 2, 3, 6, 7

Ch. 2: pp. 38 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17

Ch. 3: pp. 56-57 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 15

pp. 137 18, 19, 20,

Ch. 4: pp. 72-73 1, 2, 3, 4, 5, 6, 7,

Ch. 20: pp. 421-2 1, 2, 3, 4, 5, 8, 9, 10, 11, 12, 13

pp. 448-9 11, 12, 13

Ch. 23: p. 487 1, 2, 3, 4, 5, 6, 7, 8, 11

(See answers to Key Questions in textbook, and answers to other questions in this Coursebook)

Suggested Study Guide Questions:

(Please see the Syllabus section "How to Pass Economics ... #3" before doing these problems)

Ch. 1:

Multiple-Choice Questions - pp. 4-6: 6, 8, 9, 10, 20

Multiple-Choice Questions - pp. 10-12: 1, 2, 4, 5, 6, 7, 11, 12, 15, 16, 17, 20

Problems - pp. 12-15: 1, 2a, 2b, 4,

Ch. 2:

Multiple-Choice Questions - pp. 21-23 1, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 17, 18, 19, 20, 21, 22, 23, 24, 25

Problems - pp. 23-25 1, 2, 3, 4, 5,

Ch. 3:

Multiple-Choice Questions - pp. 31-33 ALL

Problems - pp. 33-35 1, 2, 3, 5, 7

Multiple-Choice Questions - pp. 78-79 26, 27, 28, 29, 30

Ch 4:

Multiple-Choice Questions - pp. 43-44 1, 3, 4, 5, 6, 8, 9, 11, 13,17, 20

Multiple-Choice Questions - pp. 200-201 9, 10, 11, 12, 13, 14, 18, 19, 20,

Problems - pp. 202-203 3, 4, 5

Ch. 20:

Multiple-Choice Questions - pp. 243-5 1, 2, 3, 4, 5, 6, 7, 10, 11, 12, 19, 20, 21, 22, 23, 24, 25

Problems - pp. 245-247 1

Multiple-Choice Questions - pp. 262-3 30, 31, 32, 33, 34, 35

Ch. 23:

Multiple-Choice Questions - pp. 285-7 1, 2, 3, 4, 5, 6, 8, 9, 11, 12, 13, 14, 16, 17, 18, 19, 20

Problems - pp. 287 1



The Nature and Method of Economics and the 4 Es

I. What Is Economics?

the study of how we choose to use limited resources to obtain the maximum satisfaction of unlimited human wants

"study of"



maximizing satisfaction

II. "Study Of" -- Using theories (pp. 4-5)

A. based on facts

B. simplifications

C. generalizations

D. abstractions

E. ceteris paribus

III. Why Study Economics? (pp. 2-3)

IV. The Economic Perspective

A. Scarcity -- Limited resources and Unlimited wants

B. The necessity of choice

1. options for dealing with scarcity

a. economic growth

b. reducing wants

c. use existing resources wisely = maximizing satisfaction

V. Maximizing Satisfaction -- the Four Es (pp. 23-24)

A. Productive Efficiency

1. definition

a. not using more resources than necessary

b. using resources where they are best suited

c. using appropriate technology

2. examples

B. Allocative Efficiency

1. definition

2. examples

C. Equity

1. definition

2. examples

D. Full Employment

1. definition

2. examples

VI. Economic Models (pp. 14-17)

A. Demonstrating economic concepts

B. Line Graphs

1. construction

2. inverse and direct relationships

3. slope

a. linear (straight) graph

b. nonlinear (bent) graph


The Economizing Problem: Making Choices

I. The Necessity of Choice -- Production Possibilities

A. The Economizing Problem -- The Necessity of Choice

1. Unlimited Wants

2. Limited resources and resource payments

a. land -- rent

b. capital -- interest

c. labor -- wages

d. entrepreneurial ability -- profits or losses

B. Production Possibilities -- Demonstrating the Necessity of Choice

1. Production Possibilities Table

a. shows the MAXIMUM POSSIBLE LEVELS OF PRODUCTION given the assumptions

b. assumptions

1) fixed resources
2) fixed technology
3) productive efficiency
4) full employment
5) only two goods

c. the necessity of choice -- Unattainable combinations

2. Production Possibilities Curve

a. the necessity of choice -- Unattainable combinations

b. opportunity costs

1) ALL costs in economics are opportunity costs

2) definition

3) examples

4) calculating opportunity costs

c. law of increasing costs

1) definition

2) shape of the PPC -- concave

3) rationale

d. unemployment

e. productive inefficiency

f. economic growth

1) definition

2) causes

3) graphically


5) a shrinking PPC?

6) non-proportional growth

g. present choices, future possibilities

h. optimum product mix? (allocative efficiency?)

C. Real World Applications

1. microeconomic budgeting

2. going to war

3. discrimination

4. lumber vs. owls

5. productivity slowdown

6. growth: Japan vs. U.S.

7. international trade

8. famine in Africa

8. Castro's Cuba

II. Economic Systems -- the "isms"

A. Criteria

1. who owns?

2. who decides?

B. Types

1. pure capitalism

2. command economy

3. mixed systems

4. traditional economy

C. All modern economic systems are mixed systems

III. The Circular Flow Model

A. Two Markets

1. product market

a. how much to buy

b. how much to produce

2. resource market

a. how many to hire

b. how much we earn

B. Two Flows

1. real flow

2. money flow

C. Reversal of Roles

D. Limitations


Understanding Individual Markets: Demand and Supply

I. Demand

A. Definition

1. a schedule

2. various quantities

3. willing and able

4. various prices

5. given time period

6. ceteris paribus

7. demand is NOT how much we buy

B. Demand Schedule and Curve

C. Law of Demand

1. there is an inverse relationship between price and quantity demanded

2. why?

a. common sense

b. diminishing marginal utility

c. income effects

d. substitution effects

D. Market Demand

1. definition

2. graphically (fig. 4-2)

E. Determinates of Demand

1. the price of the product

2. the non-price determinates of demand

II. Two Kinds of Changes Involving Demand

A. Change in Quantity Demanded

1. caused ONLY by a change in the PRICE of the product

2. a movement ALONG a SINGLE demand curve

B. Change in Demand

1. shifting the demand curve / a new demand schedule

a. an increase in demand

b. a decrease in demand

2. caused by a CHANGE in the non-price determinates of demand

a. Pe -- expected price

b. Pog -- price of other goods

1) substitute goods

2) complementary goods

3) independent goods

c. I -- income

1) normal goods

2) inferior goods

d. N -- number of POTENTIAL consumers

1) population change

2) expanded marketing area

3) new competitor

(changes individual demand curve but NOT market demand curve)

4) change in eligible consumers (i.e. drinking age)

e. T -- tastes and preferences

III. Supply

A. Definition

1. a schedule

2. various quantities

3. willing and able

4. various prices

5. given time period

6. ceteris paribus

7. supply is NOT the quantity available for sale

B. Supply Schedule and Curve

C. Law of Supply

1. there is a direct relationship between price and quantity supplied

2. why?

a. common sense

b. increasing costs because some resources are fixed

c. increasing costs because not all resources are identical

D. Market Supply

E. Determinates of Supply

1. the price of the product

2. the non-price determinates of supply

IV. Two Kinds of Changes Involving Supply

A. Change in Quantity Supplied

1. caused ONLY by a change in the PRICE of the product

2. a movement ALONG a SINGLE supply curve

B. Change in Supply

1. shifting the supply curve / a new supply schedule

a. an increase in supply

b. a decrease in supply

2. caused by a CHANGE in the non-price determinates of supply

a. Pe -- expected price

b. Pog -- price of other goods ALSO PRODUCED BY THE FIRM

c. Pres -- price of resources

d. T --technology

e. T --taxes and subsidies

f. N -- number of sellers

V. Market Equilibrium -- Equilibrium Price and Quantity

A. Market Equilibrium

1. define equilibrium

2. find market equilibrium

B. Market Disequilibrium

1. surpluses

2. shortages

VI. Changes in Demand AND Supply

A. Case 1: D changes and supply stays the same

B. Case 2: S changes and demand stays the same

C. Case 3: D and S both change

1. S increases, D decreases

2. S decreases, D increases

3. S increases, D increases

4. S decreases, D decreases


Pure Capitalism and the Market System: The Market and the 4 Es

I. Capitalist Ideology

A. Basic Characteristics

1. private property

2. freedom of enterprise and choice

3. role of self interest

4. competition

a. large numbers

b. free entry and exit

5. markets and prices

6. limited role for government

B. Other Characteristics

1. extensive use of capital goods

2. specialization and efficiency

a. productive efficiency

b. division of labor

c. geographic specialization

d. international specialization

3. use of money

a. medium of exchange

b. why use money?

1) barter

2) coincidence of wants

3) money makes specialization possible

II. The Economic Basis for Specialization and Exchange (Trade)

A. Why we specialize and exchange?

1. advantages and disadvantages

a. advantage: larger total output / higher living standards

b. disadvantage: less independence / more interdependence

2. the basis for specialization and exchange

a. differences in resource endowments

b. differences in preferences

c. differences in productivity

d. differences in opportunity costs

B. Differences in Opportunity Costs: Comparative Advantage

1. production possibilities: self sufficiency

2. specialization

a. comparative advantage

b. calculating opportunity costs

3. trading possibilities: more total output

"Specialization according to comparative advantage results in a more efficient allocation of the world's resources, and larger outputs ...." (McConnell and Brue 1993)

III. The Market System at Work

A. The Five Fundamental Questions and the Four "Es"

1. match the following:










B. The Five Questions

1. WHAT? (Determining What is to be Produced)

2. HOW? (Organizing Production)

3. FOR WHOM? (Distributing Total Output)

the rationing function of prices

4. HOW ADAPT? (Accommodating Change)

the guiding function of prices

C. The Case FOR the Market System (Capitalism)

1. allocative efficiency

2. productive efficiency

3. equity?

4. full employment?

OUTLINE -- Chapter 20

International Trade: Specialization, Exchange, and Efficiency

I. Introduction

A. Should We Have Free Trade With Mexico?

B. Why or Why Not?

II. The Economic Basis for Specialization and Exchange -- Trade

A. Pre-quiz

B. Why we specialize and exchange?

1. advantages and disadvantages

a. advantage: larger total output / higher living standards

b. disadvantage: less independence / more interdependence

2. the basis for specialization and exchange

a. differences in resource endowments

b. differences in preferences

c. differences in productivity

d. differences in opportunity costs

C. Differences in Productivity: Absolute Advantage

1. production possibilities: self sufficiency

2. specialization

3. trading possibilities: more total output

C. Differences in Opportunity Costs: Comparative Advantage

1. production possibilities: self sufficiency

2. specialization

a. comparative advantage

b. calculating opportunity costs

3. trading possibilities: more total output

"Specialization according to comparative advantage results in a more efficient allocation of the world's resources, and larger outputs ...." (McConnell and Brue 1993)

4. trade with increasing costs

a. review: law of increasing costs

b. result: specialization is less than 100%

5. terms of trade

a. definition

b. minimum and maximum terms of trade

c. actual terms of trade

III. International Trade

A. Unique Aspects of International Trade

1. mobility differences

2. currency differences

3. politics

B. The Facts of International Trade (pp. 399-400)

C. Trade Barriers

1. types

a. tariffs

1) revenue tariffs
2) protective tariffs

b. import quotas

c. nontariff barriers

d. voluntary export restrictions

2. why trade barriers exist -- special-interest effect

a. who gains from trade barriers?

b. who loses from trade barriers?

c. why do trade barriers look good?

3. the COSTS of trade barriers (pp. 415-417)

a. costs to society

b. impact on income distribution

"The gains which trade barriers create for protected industries come at the expense of much greater losses for the economy as a whole.: (McConnell and Brue 1993)

D. The Case FOR Protection (Trade Restrictions)

1. Military Self-Sufficiency Argument

2. Increase Domestic Employment

a. job creation from imports

b. fallacy of composition

c. retaliation

d. long-run feedbacks

3. Diversification for Stability

4. Infant-Industry Argument

a. counterarguments

b. strategic trade policy

5. Protection Against "Dumping"

a. driving out competitors

b. price discrimination and economies of scale

6. Cheap foreign Labor

E. Summing Up

F. International Trade Policy

1. Generalized Trade Liberalization


b. G.A.T.T.

c. European Economic Community

d. others

2. Aggressive Export Promotion

3. Bilateral Negotiations

G. Trade Deficits (pp. 441- 445)

1. recent U.S. trade deficits

2. causes

a. the rise of the dollar

1) large federal budget deficits
2) tighter monetary policy

b. rapid economic growth in the U.S.

3. effects

a. increased current domestic consumption

b. increased American indebtedness

4. reducing the trade deficit

a. reduction of the budget deficit

b. economic growth abroad

c. other "remedies"

1) easy money policy
2) protective tariffs
3) recession
4) increased American competitiveness
5) direct foreign investment

OUTLINE -- Chapter 23

Economies in Transition

I. Command Economies: Ideology and Institutions

A. Marxian Ideology

B. Institutions

1. state ownership

2. central economic planning

II. Central Planning and its Problems

A. Goals

B. The Coordination Problem

III. Communism's Failures

A. Declining Growth

B. Poor Product Quality

C. Failure to Meet consumer Expectations

IV. Causes of the Collapse

A. Military burden

B. Agricultural Drag

C. More Resource Inputs vs. Increased Efficiency

D. Planning Problems

E. Inadequate Success Indicators

F. Incentive Problems

V. Transition to a Market Economy

A. Policies

1. Privatization

2. Promotion of Competition

3. Limited and Reoriented Role for Government

4. Price Reform: removing Controls

5. Joining the World Economy

6. Macroeconomic Stability

B. Public Support?

VI. Role of Advanced Nations

A. Foreign Aid

B. Private Investment

C. Membership in International Institutions

VII. A Progress Report and Future Prospects


Suggested Textbook Questions


Chapter 1 - pp. 12-13 1, 2, 3, 4, 5, 13, 14

pp. 19-20 1, 2, 3, 4, 6, 7

1-1 (Key Question) Explain in detail the interrelationships between economic facts, theory, and policy. Critically evaluate: "The trouble with economics is that it is not practical. It has too much to say about theory and not enough to say about facts."

Answers to Key Questions appear in the text.

1-2 Analyze and explain the following quotation:

"Facts are seldom simple and usually complicated; theoretical analysis is needed to unravel the complications and interpret the facts before we can understand them ... the opposition of facts and theory is a false one; the true relationship is complementary. We cannot in practice consider a fact without relating it to other facts, and the relation is a theory. Facts by themselves are dumb; before they will tell us anything we have to arrange them, and the arrangement is a theory. Theory is simply the unavoidable arrangement and interpretation of facts, which gives us generalizations on which we can argue and act, in the place of a mass of disjointed particulars."

Economic theories must be based on facts, on what happens in the real world. But it is not possible to determine what facts to gather from the real world without having some idea of what we are looking for, of what sort of relationship we expect to find. But we cannot accept the theory as realistic --as proven-- until we test it with the facts to see if the theory can be supported.

There is, then, a continual interplay between facts and theory. We need the theory --or at least the beginnings of one-- to know what facts to gather. We need the facts to find out whether we have indeed derived a realistic theory or have begun to do so. As we then gather more facts, we will continuously be making the theory more realistic.

1-3 Of what significance is the fact that economics is not a laboratory science? What problems may be involved in deriving and applying economic principles?

Natural scientists working in their laboratories can hold other things equal with great precision and thus their experiments can be controlled. In this way, the results achieved by one scientist can be verified by an identical experiment in another laboratory.

The "laboratory" of economists is the whole world where many things are changing at once. Thus economists cannot carry out controlled experiments. They can only assume "other things equal" for the purpose of analysis; they are in fact saying "if other things do not change, then this will be the result."

The result is that economic principles or "laws" are less precise and certain than, say, the law of gravity. Observation allows economists to predict that consumers as a group (or "collectively") will spend, say, 90 percent of any decrease in personal income taxes, other things equal. But not everyone will spend 90 percent more and, in fact, other things are certain to be changing. Thus, economic principles are often stated in terms of probabilities. In social science, nothing is ever a hundred percent certain. But the fact that repeated observations allow one to predict a 95 percent probability of something happening is still very useful for the formulation of economic policies based on this probability.

1-4 Explain each of the following statements:

(a) "Like all scientific laws, economic laws are established in order to make successful prediction of the outcome of human actions."

The gathering of appropriate economic facts enables economists to analyze them to determine their cause-and-effect relationship. This relationship, if confirmed by sufficient observations, will be expressed in the form of an economic law, which will then have predictive value, in the sense that what has happened in given circumstances ("other things equal") in the past is likely to happen in the future. Laws of the natural sciences --for example, the law of gravity-- can be taken to have absolutely certain predictive value: anything dropped within the earth's gravitational field will eventually fall to earth. Economic laws have similar, but not identical predictive value, in that they can only be expressed in terms of probability. This is so because human beings in their economic acts --as in everything else--are themselves not as predictable as the subjects of the natural sciences. Moreover, whereas natural scientists can carry out rigidly-controlled experiments in a laboratory, economists, who have the whole world as their laboratory, cannot do so.

(b) "Abstraction is the inevitable price of generality indeed abstraction and generality are virtually synonyms."

To generalize means to reduce information or facts to general laws. In economics, it is impossible to determine cause-and-effect relationships --that is, general laws-- without reducing the infinity of facts found in the real world to those that analysis indicates are most relevant to the relationships being studied. This reducing is called abstracting.

(c) "Numbers serve to discipline rhetoric."

Rhetoric is the art of persuasive or impressive speaking or writing. Fine words purporting to describe some economic relationship will never be accepted as proven until they have been tested and retested with real-world data; that is, with figures.

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

(a) The unemployment rate in the United States was 5.9 percent in September 1994.

(b) The Alpo dogfood plant in Bowser, Iowa, laid off 15 workers last month.

(c) An unexpected freeze in central Florida reduced the citrus crop and caused the price of oranges to rise.

(d) Our national output, adjusted for inflation, grew by about 3.1 percent in 1993.

(e) Last week Manhattan Chemical Bank lowered its interest rate on business loans by one-half of 1 percentage point.

(f) The consumer price index rose by more than 2.7 percent in 1993.

Answers to Key Questions appear in the text.

1-13 (Key Question) Use the economic perspective to explain why someone who normally is a light eater at a standard restaurant may become somewhat of a glutton at a buffet-style restaurant which charges a single price for all you can eat.

Answers to Key Questions appear in the text.

1-14 (Last Word) Explain how the economic perspective can be used to explain the behavior of customers in fast-food restaurants.

Customers select the shortest line believing that it will reduce their time cost in obtaining food, since time is a limited resource. When a cashier opens a new line, again customers decide whether the inconvenience of shifting lines is worth the possible benefit of saving more time. Finally, some customers have imperfect information and come to the restaurant not expecting long lines. If they find long lines, they may leave because they decide that the cost of time spent waiting in line is not worth the benefit. Perhaps, they expect that there is another place to visit where they can get the food more quickly despite the time spent in going to another restaurant. In each decision, the customer is implicitly weighing the cost of time spent in alternative ways to obtain their food.

Chapter 1 - Appendix (pp. 19-20 1, 2, 3, 6, 7)

1a-1 (Key Question) Briefly explain the use of graphs as a means of presenting economic principles. What is an inverse relationship? How does it graph? What is a direct relationship? How does it graph? Graph and explain the relationships one would expect to find between (a) the number of inches of rainfall per month and the sale of umbrellas, (b) the amount of tuition and the level of enrollment at a university, and (c) the size of a university's athletic scholarships and the number of games won by its football team. In each case cite and explain how considerations other than those specifically mentioned might upset the expected relationship. Is your second generalization consistent with the fact that, historically, enrollments and tuition have both increased? If not, explain any difference.

Answers to Key Questions appear in the text.

1a-2 (Key Question) Indicate how each of the following might affect the data shown in Table 2 and Figure 2 of this appendix:

(a) GSU's athletic director schedules higher-quality opponents.

(b) GSU's Fighting Aardvarks experience three losing seasons.

(c) GSU contracts to have all its home games televised.

Answers to Key Questions appear in the text.

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

Income Saving

(per year) (per year)

$15,000 $1,000

0 -500

10,000 500

5,000 0

20,000 1,500

1a-6 (Key Question) The accompanying diagram shows curve XX and three tangents at points A, B, and C. Calculate the slope of the curve at these three points.

Answers to Key Questions appear in the text.

1a-7 In the accompanying diagram, is the slope of curve AA' positive or negative? Does the slope increase or decrease as we move from A to A'? Answer the same two questions for curve BB'.

Slope of AA' is positive (rising from left to right). The slope increases as we move from A to A'.

Slope of BB' is negative (dropping from left to right). The slope increases as we move from B to B'.

The slopes of both curves are tending to infinity as they continue to move to the right.

Chapter 2: pp. 38 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17

2-1 "Economics is the study of the principles governing the allocation of scarce means among competing ends when the objective of the allocation is to maximize the attainment of the ends." Explain.

The basic goal of economic activity is consumption. Capital equipment --factories, for example-- are of no use in themselves but only for the consumer goods and services that result from the production process. Because the means are limited relative to the wants of consumers, decisions must be made about how to allocate the scarce resources. Naturally, the objective of the allocation is to satisfy as many wants as possible --to maximize the attainment of the ends-- since not every want can be satisfied. A basic economic assumption is that more is better, so it is best to satisfy as many wants as possible with the limited means available.

2-2 Comment on the following statement from a newspaper article: "Our junior high school serves a splendid hot meal for $1 without costing the taxpayers anything, thanks in part to a government subsidy."

Obviously the writer is confused. Government subsidies come from government revenues and taxpayers are the source of tax revenues. It may be true that local property taxes which fund the junior high school, are not being used for the lunches, but the federal government's funds do come from taxpayers across the country, including those in the town with the junior high. This example helps support the saying, "there ain't no such thing as a free lunch!"

2-3 Critically analyze: "Wants aren't insatiable. I can prove it. I get all the coffee I want to drink every morning at breakfast." Explain: "Goods and services are scarce because resources are scarce." Analyze: "It is the nature of all economic problems that absolute solutions are denied us."

It may be that you get all the coffee you want on a particular morning, but will that satisfy your wants forever? Not if you want coffee in the future. Therefore, even your desire for coffee is insatiable over time.

Goods and services are the product of resources. If resources were abundant without limit, then we would not have a scarcity of the products they produce.

Economic problems are problems of relative scarcity --wants exceed resources in the relative sense. We cannot absolutely solve all of our economic problems; that is, satisfy all of everyone's wants and needs. If all our wants were completely fulfilled, nothing would have a price --why pay for anything if you've got everything already? And if there were no unfulfilled wants there would be no economic resources --why pay for an input when you've got all the outputs you could ever need? The fact that totally free goods and services do not exist provides support for the notion that total fulfillment of our wants is impossible.

2-4 What are economic resources? What are the major functions of the entrepreneur?

Economic resources are of four main types: labor, land (natural resources), real capital (machines, factories, buildings, etc.,) and entrepreneurs. Economic resources are also called factors of production or inputs in the productive process. As these names imply, economic resources are whatever are required to produce the outputs desired by society. Since certain outputs are desired, they command a price and so, therefore, do economic resources. This can lead to some things being economic resources in some circumstances but not in others. Water in the middle of a lake, for example, is not an economic resource: Anyone can have it free. But the same water piped to a factory site is no longer free: Its movement must be paid for by taxes or by a specific charge. It is now an economic resource because the factory owner would not pay for its delivery unless the water was to be used in the factory's production. These four types of resources are highlighted in the circular flow diagram where the type of income accruing to each type of resource is shown.

Entrepreneurs are risk-takers: They coordinate the activities of the other three inputs for profit --or loss, which is why they are called risk-takers. Entrepreneurs sometimes manage companies that they own but a manager who is not an owner is not necessarily an entrepreneur. Entrepreneurs are also innovators, or perhaps inventors, and profits help to motivate such activities.

2-5 (Key Question) Why is the problem of unemployment a part of the subject matter of economics? Distinguish between allocative efficiency and productive efficiency. Give an illustration of achieving productive, but not allocative, efficiency.

Answers to Key Questions appear in the text.

2-6 (Key Question) The following is a production possibilities table for war goods and civilian goods:

Type of Production Production alternatives


Automobiles 0 2 4 6 8

Rockets 30 27 21 12 0

(a) Show these data graphically. Upon what specific assumptions is this production possibilities curve based?

(b) If the economy is at point C, what is the cost of one more automobile? One more rocket? Explain how this curve reflects increasing opportunity costs.

(c) What must the economy do to operate at some point on the production possibilities curve?

Answers to Key Questions appear in the text.

2-7 What is the opportunity cost of attending college?

The opportunity cost of attending college (and of doing anything else) consists of the income forgone while attending college (and of doing anything else such as enjoying leisure) and the value of the goods that the student or the student's parents sacrifice in order to pay tuition and buy books, and other items necessary for college but not necessary otherwise.

2-8 Suppose you arrive at a store expecting to pay $100 for an item, but learn that a store two miles away is charging $50 for it. Would you drive there and buy it? How does your decision benefit you? What is the opportunity cost of your decision? Now suppose you arrive at a store expecting to pay $6000 for an item, but learn that it costs $5950 at the other store. Do you make the same decision as before? Perhaps surprisingly, you should! Explain why.

Driving to the other store to save $50 does involve some cost in terms of time and inconvenience. However, for most of us the time it takes to drive two miles would be worth $50. For example, if it takes about ten minutes extra time and a negligible amount of gasoline (unless your time is worth $300 an hour, or $50 per each ten-minute period), it would benefit you to drive to the other store. While in the second case, $50 may seem like less compared to the $6000 total price, for you the $50 is still a $50 savings, exactly the same as in the first case. Therefore, you should apply the same reasoning. Is the $50 benefit from driving the extra two miles worth the cost? The conclusion should be the same in both cases.

2-9 (Key Question) Specify and explain the shapes of the marginal-benefit and marginal-cost curves and use these curves to determine the optimal allocation of resources to a particular product. If current output is such that marginal cost exceeds marginal benefit, should more or less resources be allocated to this product? Explain.

Answers to Key Questions appear in the text.

2-10 (Key Question) Label point G inside the production possibilities curve you have drawn for question 6. What does it indicate? Label point H outside the curve. What does this point indicate? What must occur before the economy can attain the level of production indicated by point H?

Answers to Key Questions appear in the text.

2-11 (Key Question) Referring again to question 6, suppose improvement occurs in the technology of producing rockets but not in the production of automobiles. Draw the new production possibilities curve. Now assume that a technological advance occurs in producing automobiles but not in producing rockets. Draw the new production possibilities curve. Finally, draw a production possibilities curve which reflects technological improvement in the production of both products.

Answers to Key Questions appear in the text.

2-12 Explain how, if at all, each of the following affects the location of the production possibilities curve.

(a) Standardized examination scores of high school and college students decline.

(b) The unemployment rate falls from 9 to 6 percent of the labor force.

(c) Defense spending is reduced to allow government to spend more on health care.

(d) Society decides it wants compact discs rather than long-playing records.

(e) A new technique improves the efficiency of extracting copper from ore.

(f) A new "baby boom" increases the size of the nation's work force.

(a) Assuming scores indicate lower skills, then productivity should fall and this would move the curve inward.

(b) Should not affect location of curve. Production moves from inside the curve toward frontier.

(c) Should not affect location of curve. Resources are allocated away from one type of government spending toward another (health care).

(d) Should not affect location of curve. Resources are shifted from record to CD production.

(e) The curve should shift outward as more production is possible with existing resources.

(f) The curve should shift outward as more labor resources are available for production.

2-13 Explain: "Affluence tomorrow requires sacrifice today."

This quote refers to the fact that economic growth and a rising standard of living in the future require investment today. Society can choose to consume all of its income today, or it can set aside some of it for investment purposes. Productive resources that go for investment goods today, e.g., new factories, machines, equipment, are obviously not being used for producing consumer goods. Therefore, consumption is being sacrificed today so that investment goods can be produced with some of today's resources.

2-14 Explain how an international trade deficit may permit an economy to acquire a combination of goods in excess of its domestic production potential. Explain why nations try to avoid trade deficits.

An international trade deficit means a country is importing more than it is exporting. If it is at full employment and is using the best productive techniques (that is, it is at full production), the excess of its imports over its exports means that it will enjoy more consumer and capital goods (those of other nations) beyond what it can produce itself. If the import surplus is weighted towards consumer goods, this will be satisfying for its present consumers: They will be consuming more than their own economy can at present produce. But a nation can only have an import surplus if it is using more foreign money than it is at present earning. If it is a large net international creditor (as the United States was until the mid-1980s), it can use the dividends and interest on its investments abroad to pay for its import surplus. But if it is a net international debtor (as the United States now is), it can have an import surplus only by borrowing or selling assets to foreigners. Thus, nations try to avoid trade deficits because of the danger of eventually going into debt or going deeper into debt. However, this may not be a major concern if the foreigners do not have a major share of the country's assets.

International debts can only be paid off by future trade surpluses --by forgoing part of future consumption to produce more commodities for foreigners. Moreover, if the trade deficit occurs when the nation is not on its production possibilities frontier, then the deficit makes no economic sense at all: Why borrow from foreigners to buy from them when we could produce the commodities ourselves by moving outward to the frontier?

If a nation is running a trade deficit when it is on its production possibilities frontier, then it is best to have the import surplus weighted towards capital goods, not consumer goods. Through the import of capital goods beyond its own present productive capacity, the nation will be increasing its productive capacity --pushing its frontier outwards. This may allow it to achieve a greater productive base and perhaps an export surplus in the future (to repay its foreign borrowing) without having to cut back its consumption in the future.

2-15 Contrast how pure capitalism, market socialism, and a command economy try to cope with economic scarcity.

Pure capitalism allows the market or price system to cope with economic scarcity. The more a commodity is desired, the higher its price goes. This rations out of the market those who can no longer afford the commodity and simultaneously encourages suppliers to produce more or to offer more for sale. Thus there can never be a shortage: All who can pay the price will get all they wish at that price. The fact that commodities have prices proves that scarcity still exists, but scarcity will tend to be less under pure capitalism; any increase in demand will result in higher prices, which will increase profits of the suppliers and induce them to increase production.

Under a command economy, all the major decisions on production are made by a central planning body, which tries to match supply with expected demand. By also setting the prices, it can ensure that if everything is bought, all will come out even: Total incomes will have been spent and there will be neither shortages nor surpluses. At first sight this seems to ensure better than pure capitalism that everyone will get a fair share of the essentials. There are problems, however, in estimating precisely the demand for each and every commodity and, in the absence of a profit motive, of ensuring that all commodities are made as efficiently as they could be. The result is surpluses of badly made commodities that few desire. Shortages of other products exist because the government sets some prices intentionally low. This is true especially for necessities.

Market socialism tries to get the best of both worlds; a central planning agency to determine what and how much should be made and a price or market system to equate quantity supplied and quantity demanded in the market place. However, in the absence of an all-pervading profit motive or an alternative system of rewarding excellence in production, shoddy goods will still be produced year after year, and there will be little incentive to find and implement improved technologies. Neither the command economy nor market socialism overcomes economic scarcity. Indeed, to the extent that either system fails to reward producers for producing as best they can what consumers wish, production is less than under pure capitalism and overall scarcity is increased.

2-16 Describe the operation of pure capitalism as portrayed by the circular flow model. Locate resource and product markets and emphasize the fact of scarcity throughout your discussion. Specify the limitations of the circular flow model.

In the simple circular flow model only two sectors are shown, households and business. This means that government's role is assumed to be noneconomic, which is one of the weaknesses of the simple diagram.

The resource market at the top of the diagram indicates that the household sector (which owns everything) supplies land (natural resources), labor, (physical) capital, and entrepreneurial ability. The business sector, on the demand side of the resource market, buys these resources to produce commodities and services, thereby incurring costs, which flow as money income (rent, wages, interest, and profits) to the households. With these incomes, households go to the product market to buy the goods and services produced (supplied) to the product market at the bottom of the diagram. Households are on the demand side of the product markets. The household incomes derived from their supply of resources to businesses thus flows back to businesses as revenue, where the revenue is then used for the next cycle of production.

It must be stressed that no more is being produced in subsequent cycles than were produced in the first. The supply of resources and products is limited or scarce. The model does not illustrate economic growth.

The model's limitations are in its simplicity. Government and foreign sectors are left out. Transactions between businesses or between households are left out. Saving is ignored, so instability caused by insufficient product demand is nonexistent in the model. Finally, no explanation of how prices are set is given.

2-17 (Last Word) What are the major causes of Cuba's diminishing production possibilities?

Three causes are mentioned in the text. First, central planning fails to accurately assess consumer wants, to minimize production costs, and to provide adequate incentives for workers and businesses. Second, the U.S. trade embargo has denied Cuba access to the nearby vast American market. Third, aid from the former Soviet Union has ended.

Chapter 3: pp. 56-57 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 15

3-1 Explain the law of demand. Why does a demand curve slope downward? What are the determinants of demand? What happens to the demand curve when each of these determinants changes? Distinguish between a change in demand and a change in the quantity demanded, noting the cause(s) of each.

As prices change because of a change in supply for a commodity, buyers will change the quantity they demand of that item. If the price drops, a larger quantity will be demanded. If the price rises, a lesser quantity will be demanded.

The demand curve slopes downward because of the substitution and income effects. When the price of a commodity decreases relative to that of substitutes, a buyer will substitute the now cheaper commodity for those whose prices have not changed. At the same time, the decreased price of the commodity under discussion will make the buyer wealthier in real terms. More can be bought of this commodity (as well as of others whose prices have not changed). Thus, the substitution and income effects reinforce each other: More will be bought of a normal (or superior) commodity as its price decreases. On a graph with price on the vertical axis and quantity on the horizontal, this is shown as a demand curve sloping downward from left to right.

The fundamental determinant of demand is the price of the commodity under consideration: a change in price causes movement along the commodity's demand curve. This movement is called a change in quantity demanded. Decreased price leads to movement down the demand curve: There is an increase in quantity demanded. Increased price leads to movement up the demand curve: There is a decrease in quantity demanded.

In addition, there are determinants of demand, which are factors that may shift the demand curve, i.e., cause a "change in demand." These are the number of buyers, the tastes (or desire) of the buyers for the commodity, the income of the buyers, the changes in price of related commodities (substitutes and complements), and expectations of the buyers regarding the future price of the commodity under discussion.

The following will lead to increased demand: more buyers, greater desire for the commodity, higher incomes (assuming a normal good), lower incomes (assuming an inferior good), an increased price of substitutes, a decreased price of complements, and an expectation of higher future prices. This increased demand will show as a shift of the entire demand curve to the right.

The reverse of all the above will lead to decreased demand and will show as a shift of the entire demand curve to the left.

3-2 (Key Question) What effect will each of the following have on the demand for product B?

(a) Product B becomes more fashionable.

(b) The price of substitute product C falls.

(c) A decline in incomes if B is an inferior good.

(d) Consumers anticipate the price of B will be lower in the near future.

(e) The price of complementary product D falls.

(f) Foreign tariff barriers on B are eliminated.

Answers to Key Questions appear in the text.

3-3 Explain the following news dispatch from Hull, England: "The fish market here slumped today to what local commentators called a `disastrous level' --all because of a shortage of potatoes. The potatoes are one of the main ingredients in a dish that figures on almost every cafe menu --fish and chips."

The shortage of potatoes either meant they were not available in the required quantities at any price (i.e., that the quantity demanded greatly exceeded the quantity supplied at the market price, for that is how a "shortage" is defined) or that there was an exceptional scarcity of potatoes so that their price was far above normal. In any event, the restaurants could not get enough potatoes at what they considered profitable prices.

Fish and chips are complements. The sharp increase in the price of potatoes (because of decreased supply) has led to a decreased demand for fish and to a subsequent drop in its price to "a disastrous level."

3-4 Explain the law of supply. Why does the supply curve slope upward? What are the determinants of supply? What happens to the supply curve when each of these determinants changes? Distinguish between a change in supply and a change in the quantity supplied, noting the cause(s) of each.

As prices rise because of increased demand for a commodity, producers find it more and more profitable to increase the quantity they offer for sale; that is, the supply curve will slope upward from left to right. Clearly, firms would rather sell at a higher price than at a lower price. Moreover, it is necessary for firms to demand a higher price as they increase production. This comes about because as they produce more and more they start to run up against capacity constraints and costs rise. At any given time, a plant has a given size. As production increases, the firm will need to add an extra shift and then a third shift, both perhaps at higher wages. It may run out of warehouse space and have to rent at higher cost from another firm. It may have to pay extra to get increasingly urgent raw material, and so on.

The fundamental determinant of supply is the price of the commodity. As price increases, the quantity supplied increases. An increase in price causes a movement up a given supply curve. A decrease in price causes a movement down a given supply curve.

The non-price determinants of supply are: resource (input) prices, technology, taxes and subsidies, prices of other related goods, expectations, and the number of sellers. If one or more of these change, there will be a change in supply and the whole supply curve will shift to the right or the left.

The following will cause an increase in supply: a decrease in resource (input) prices; improved (lower cost) technology; a decrease in business taxes, an increase in subsidies to business; a decrease in the price of another commodity that this firm was making provided that commodity is a substitute in production (the firm can switch from the now lower priced one to our commodity); an expectation of lower prices in the future; and an increase in the number of sellers. The increase in supply caused by the noted change in one or more of the above will cause the entire supply curve to shift to the right. More will now be supplied at any given price. Alternatively expressed, any given amount will now be supplied at a lower price.

The reverse of any or all the above changes in the determinants of demand will cause a decrease in demand and will be shown as a shift of the supply curve to the left. Less will now be supplied at any given price. Alternatively expressed, any given amount will now be supplied at a higher price.

3-5 (Key Question) What effect will each of the following have on the supply of product B?

(a) A technological advance in the methods of producing B

(b) A decline in the number of firms in industry B

(c) An increase in the price of resources required in the production of B

(d) The expectation that the equilibrium price of B will be lower in the future than it is currently

(e) A decline in the price of product A, a good whose production requires substantially the same techniques as does the production of B

(f) The levying of a specific sales tax upon B

(g) The granting of a 50-cent per unit subsidy for each unit of B produced

Answers to Key Questions appear in the text.

3-6 "In the corn market, demand often exceeds supply and supply sometimes exceeds demand." "The price of corn rises and falls in response to changes in supply and demand." In which of these two statements are the terms "supply" and "demand" used correctly? Explain.

In the first statement 'supply" and "demand" are used incorrectly. Supply and demand are both schedules or curves that intersect where quantity supplied and quantity demanded are equal. One cannot talk of curves that intersect as exceeding or not exceeding each other.

Supply and/or demand can change (the entire curves can shift). Each time this happens, it will create a new intersection of the two curves which will lead to changes in the equilibrium quantity and price of corn. Thus, the terms "supply" and "demand" are used correctly in the second statement.

3-7 (Key Question) Suppose the total demand for wheat and the total supply of wheat per month in the Kansas City grain market are as follows:

Thousands Price Thousands Surplus (+)
of bushels per of bushels or
demanded bushel supplied shortage ()

85 $3.40 72 _____
80 3.70 73 _____
75 4.00 75 _____
70 4.30 77 _____
65 4.60 79 _____
60 4.90 81 _____

(a) What will be the market or equilibrium price? What is the equilibrium quantity? Using the surplus-shortage column, explain why your answers are correct.

(b) Using the above data, graph the demand for wheat and the supply of wheat. Be sure to label the axes of your graph correctly. Label equilibrium price "P" and the equilibrium quantity "Q."

(c) Why will $3.40 not be the equilibrium price in this market? Why not $4.90? "Surpluses drive prices up; shortages drive them down." Do you agree?

(d) Now suppose that the government establishes a ceiling price of, say, $3.70 for wheat. Explain carefully the effects of this ceiling price. Demonstrate your answer graphically. What might prompt the government to establish a ceiling price?

Answers to Key Questions appear in the text.

3-8 (Key Question) How will each of the following changes in demand and/or supply affect equilibrium price and equilibrium quantity in a competitive market; that is do price and quantity rise, fall, remain unchanged, or are the answers indeterminate, depending on the magnitudes of the shifts in supply and demand? You should rely on a supply and demand diagram to verify answers.

(a) Supply decreases and demand remains constant.

(b) Demand decreases and supply remains constant.

(c) Supply increases and demand is constant.

(d) Demand increases and supply increases.

(e) Demand increases and supply is constant.

(f) Supply increases and demand decreases.

(g) Demand increases and supply decreases.

(h) Demand decreases and supply decreases.

Answers to Key Questions appear in the text.

3-9 "Prices are the automatic regulator that tends to keep production and consumption in line with each other." Explain.

When demand increases, prices rise. This induces producers to increase the quantity supplied as they move up their supply curves toward the new (higher) equilibrium point. The same happens in reverse when demand decreases.

When supply increases, prices drop. This induces buyers to increase the quantity demanded as they move down their demand curves toward the new (lower) equilibrium point. The same happens in reverse when supply decreases.

In each case, it is the change in price caused by the change in demand or supply that brings about the change in quantity supplied (in the case of a change in demand) and a change in quantity demanded (in the case of a change in supply). Thus, price is the automatic regulator that keeps production and consumption in line with each other.

3-10 Explain: "Even though parking meters may yield little or no net revenue, they should nevertheless be retained because of the rationing function they perform."

Even parking meters that charge, say, 25 cents an hour do perform a useful parking-spot-rationing function: When the hour is up, the car owner must either move the car or rush out to feed the meter to avoid getting a ticket. In this case it is not money or ration coupons that ration the parking space but the timing device on the meter.

3-11 Use two market diagrams to explain how an increase in state subsidies to public colleges might affect tuition and enrollments in both public and private colleges.

The state subsidies to public colleges shift the supply curve of the public colleges to the right, thus reducing tuition and increasing enrollments in these institutions. The decreased cost of public college education leads to some substitution away from the private colleges, where the enrollment demand curve shifts to the left. The final result is a lower cost of tuition in both public and private colleges. (See Figure 3-6c.)

3-12 Critically evaluate: "In comparing the two equilibrium positions in Figure 3-6a, I note that a larger amount is actually purchased at a higher price. This refutes the law of demand."

The key point here is that the second equilibrium occurs after demand has increased, that is demand has shifted because of a change in determinants, which has caused buyers to want more at every price compared to the original D1 demand curve and schedule. Each equilibrium price refers to a different demand situation. Therefore, the fact that more is purchased at a higher price when demand increases does not refute the law of demand. Note that on the second demand curve and schedule, more would still be purchased at a lower price.

3-13 Suppose you go to a recycling center and are paid 25 cents per pound for your aluminum cans. However, the recycler charges you 20 cents per bundle to accept your old newspapers. Use demand and supply diagrams to portray both markets. Can you explain how different government policies with respect to the recycling of aluminum and paper might account for these different market outcomes?

The equilibrium price of aluminum cans is not only higher than that for newspapers, but the price of newspapers is actually negative, meaning that the demand is very low relative to the supply. The demand is so low that the equilibrium quantity is at a negative price and consumers pay to have the papers "purchased." Diagrams (a) and (b) illustrate the two situations. (One might even suggest that there is a current abundance of old newspapers, and the demand is for environmental quality rather than for old newspapers. However, this complicating idea will probably confuse students and is probably not worth mentioning unless a student raises the issue.)

Various government policies could cause these different market outcomes. For example, requiring the use of recycled aluminum in can production could raise its demand; requiring refundable deposits on cans at the time of purchase could give them a value not given to newspapers; giving tax breaks for the use of recycled aluminum and not for recycled newspapers would also encourage demand for aluminum and not for newspapers.

3-15 (Last Word) Discuss the economic aspects of ticket scalping, specifying the gainers and losers.

Ticket scalping occurs in situations in which the original ticket price is set below the equilibrium price. This means that holders of tickets can find buyers who are willing to pay a higher price than that printed on the ticket. Basically, there is a shortage or the quantity demanded exceeds the quantity supplied at the original price. Some ticket holders are willing to part with their tickets by selling them at a higher price than the price they paid, and some buyers are willing to pay this higher price. In other words, both the buyers and sellers voluntarily enter into the "scalping" transaction because both expect to benefit. The buyers value the tickets more than the money, and the sellers value the money more than the tickets. The only losers in this case would be the sponsors of the event, who could have charged higher prices for the tickets originally. However, they don't lose because of the scalping, but because they originally priced the tickets below equilibrium.

Chapter 4: pp. 72-73 1, 2, 3, 4, 5, 6, 7,

4-1 "Capitalism may be characterized as an automatic self-regulating system motivated by the self-interest of individuals and regulated by competition." Explain and evaluate.

The self-regulating nature of (pure) capitalism stems from the idea that if everyone does what is best for himself or herself, all will work out for the best of society as a whole. To make a profit, the producer must produce what consumers most desire. Since a large number of producers is part of the pure competition that exists in pure capitalism, to stay in business each firm must use the best available technique to produce at as low a cost as possible. No government need do this by regulation; competition itself does the regulating. Thus consumers get the goods they most desire at the lowest possible price. It is, as Adam Smith put it in 1776, as though an invisible hand guided the self-interest of every individual to serve the interests of all.

But pure capitalism does not exist-- and never has. Economies of scale are often such that the multitude of small producers could not exist in competition with a few large-scale producers. Governments step in to provide public goods where markets fail, and government regulation is necessary in other cases, where competition is weak and monopoly power strong.

4-2 (Key Question) What advantages result from "roundabout" production? what problem is involved in increasing a full-employment economy's stock of capital goods? Illustrate this problem in terms of the production possibilities curve. Does an economy with unemployed resources face the same problem?

Answers to Key Questions appear in the text.

4-3 What are the advantages of specialization in the use of human and material resources? Explain: "Exchange is the necessary consequence of specialization."

The advantages of specialization, on an individual basis, are the opportunity to choose work according to one's natural aptitudes, the ability to perfect oneself in one line of work, and the saving of time in not having to shift continually from one task to another. On a material and regional basis, the advantage is each region can then produce that for which its resources (including climate and soil) are best suited and then trade its surplus for the surplus of other regions, which have also been producing that for which they are best suited. By specializing in its comparative advantage, each region or set of human and material resources is being used to maximize efficiency. However, when resources are specialized, they are no longer self-sufficient. To obtain the goods and services one needs, exchange is necessary.

4-4 What problems does barter entail? Indicate the economic significance of money as a medium of exchange. "Money is the only commodity that is good for nothing but to be gotten rid of. It will not feed you, clothe you, shelter you, or amuse you unless you spend or invest it. It imparts value only in parting." Explain this statement.

Barter requires the "double coincidence of wants." If you want something, you have to find someone who wishes to part with it. (No great problem --that's what stores are for.) But in a moneyless barter economy you cannot simply hand over money in exchange for what the store has. Rather, you must trade and give the store another commodity or commodities that the store wishes either for itself or to use for barter with other customers. With a very big store, you may well not have too much trouble hitting on a "double coincidence of wants": the store will take practically anything. But even at the best of times, it is clear that it is much more convenient to hand over cash, a check, or a credit card than to walk in with a sack full of goods in the hope of making a deal for what you want to "buy."

With money, then, as a medium of exchange you know precisely where you stand before you decide to buy. You know the price precisely in terms of dollars, the price of other commodities in which you are interested and you know, therefore, how much money is needed to exchange for them. You are not faced with the barter problem of having to decide whether a pound of butter really is worth a pound of nails, since yesterday you got ten pounds of potatoes for twenty-four screws! Money is a very convenient common denominator, a common measure of value that is also used as a medium of exchange.

Money itself has value only in relation to the resources, goods, and services which can be obtained from it. When people say that they want money, they really mean that they want the things that money can buy. In this sense, money imparts value only when someone parts with it.

But this quotation falsely implies that money is useful only to buy things. It is much more than that. In the first place, the quotation leaves out of consideration the value of money when saved: It affords security, the nest-egg that will see you through uncertain times. Moreover, as macroeconomics will show, variations in the money supply have real effects in the economy.

4-5 Describe in detail how the market system answers the Fundamental Questions. Why must economic choices be made?

In a market economy, those products whose production and sale provide total revenue sufficient to cover total costs, including a normal profit, will be produced.

The level of production will increase if firms are making an economic profit (more than a normal profit), and the level of production will decrease if firms are making less than a normal profit (or a loss).

The most efficient production techniques (least cost production methods) will be used to produce that output because in a market system firms face competition and the most successful firms will be those that can produce at minimum cost. If other firms do not follow these least-cost techniques, they will find their profits decline as the more efficient firms lower product prices, and eventually all will be forced to follow due to the pressure of competition.

The products will be distributed to those consumers who are willing and able to pay for them, and these consumers' choices will determine producers' decisions about the mix of products that will be produced.

The competitive market system can communicate changes in tastes to resource suppliers and entrepreneurs, thereby prompting appropriate adjustments in the allocation of the economy's resources. Profit motives also provide an incentive to technological advance and capital accumulation.

Finally, choices must be made in answering the Five Fundamental Questions because resources are limited or scarce relative to society's wants. If resources were abundant and free, virtually any system could answer the Five Fundamental Questions successfully.

4-6 Evaluate and explain the following statements:

(a) "The capitalistic system is a profit and loss economy."

(b) "Competition is the indispensable disciplinarian of the market economy."

(c) "Production methods which are inferior in the engineering sense may be the most efficient methods in the economic sense."

(a) The quotation is accurate. In a pure capitalist system producer decisions are motivated by the attempt to earn profits. Those products that enable a firm to earn at least a normal profit will be produced. If the product cannot be produced for a profit --in other words, if losses are involved in production-- the capitalist firm will respond by seeking lower cost production methods and failing that, will halt the production of goods that are not profitable. Because profits and/or losses are the motivation behind the fundamental decisions made in a capitalist system, it could be called a "profit and loss economy."

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

(c) There are some very effective engineering techniques that may be too costly in terms of the scarce resources that they would employ. For example, using computerized word processors may be a superior way to write essays and papers. However, investing in enough computers for every school child would not be efficient in the economic sense. Education can be provided by using more labor-intensive methods, with the teacher at the chalkboard and the student using pencil and paper. In another example, using a shovel to scoop snow may be inferior to a snowblower in the engineering sense, but it may be a more efficient use of resources for the middle- or low-income family who has to decide between buying groceries and using better technology to clean its driveway and sidewalk.

4-7 Explain fully the meaning and implications of the following quotation.

The beautiful consequence of the market is that it is its own guardian. If output prices or certain kinds of remuneration stray away from their socially ordained levels, forces are set into motion to bring them back to the fold. It is a curious paradox which thus ensues: the market, which is the acme of individual economic freedom, is the strictest taskmaster of all. One may appeal the ruling of a planning board or win the dispensation of a minister; but there is no appeal, no dispensation from the anonymous pressures of the market mechanism. Economic freedom is thus more illusory than at first appears. One can do as one pleases in the market. But if one pleases to do what the market disapproves, the price of individual freedom is economic ruination.

The statement that the market is its own guardian implies that there really is an invisible hand or taskmaster that watches over the decision makers in the marketplace. In a pure capitalist system where free markets exist, freedom of enterprise and freedom of choice exist. However, if one chooses to produce that which the consumer does not want, or at least doesn't want enough to cover the cost of the scarce resources employed, the producer-entrepreneur will find this freedom of enterprise limited by the decisions of consumers in the marketplace. On the demand side, consumer choice is limited by the prices of products that the consumer wants and the consumer's income, which is limited by the value that the consumer's own resources can earn in resource markets.

In other words, the freedom is to some extent illusory, because if producers ignored consumer wishes, they would likely suffer losses and eventually find themselves with no income or means to support themselves. If consumers make choices that ignore their own income potential, they, too, will soon find themselves unable to buy even the basic necessities. Personal freedom exists only in the fact that no single individual or command agency is telling economic decision makers what to do with regard to their production and consumption decisions. One is free to make one's own decisions subject to the limitations of the anonymous marketplace.

Chapter 20: pp. 421-2 1, 2, 3, 4, 5, 8, 9, 10, 11, 12, 13

pp. 448-9 11, 12, 13

20-1 Quantitatively, how important is international trade to the United States relative to other nations?

Our exports of goods and services are about 11 to 13 percent of GDP which is small relative to the proportion in many other industrialized nations. For example, the percentage is 52 percent in the Netherlands, 27 percent in Germany, 33 percent in New Zealand, and 30 percent in Canada. However, total U.S. exports and imports have more than doubled as a percent of GDP since 1965. Table 6-1 gives more detailed figures.

20-2 Distinguish among land-, labor- and capital-intensive commodities, citing an example of each. What role do these distinctions play in explaining international trade?

Land-intensive commodities include agricultural products such as corn and wheat. Labor-intensive commodities require much skilled labor in production such as transistor radios and clothing. Capital-intensive products are produced with a large amount of capital equipment and include manufactured items such as aircraft and automobiles.

These distinctions are important because they indicate the type of resources used in the production of certain products. If a nation has an abundant supply of particular resources, it can produce items that are intensive in these resources with a comparative cost advantage. On the other hand, if it has a relative scarcity of certain resources, such as land, then it will be relatively expensive to produce land-intensive products such as corn and wheat. The difference in resource abundance among nations leads to a difference in comparative costs of production, which is the basis for international trade and specialization.

20-3 Suppose nation A can produce 80 units of X by using all its resources to produce X and 60 units of Y by devoting all its resources to Y. Comparative figures for nation B are 60 of X and 60 of Y. Assuming constant costs, in which product should each nation specialize? Why? Indicate the limits of the terms of trade.

The cost ratio for the two goods in nation A is 2 units of X for 1 unit of Y; in nation B it is 1 unit of X for 1 unit of Y. The opportunity cost of producing X is lower in A (1/2 unit of Y) than it is in B (1 unit of Y). Conversely, the opportunity cost of producing Y is lower in B (1 unit of X) than it is in A (2 units of X). Nation A should produce X since it has a comparative cost advantage in the production of this good, and B should produce Y in which it has a comparative advantage.

The limits of the terms of trade for the two goods are the cost ratios in the two countries:

2X = 1Y

1X = 1Y

In other words, 1 unit of Y will be exchanged for between 1 and 2 units of X.

20-4 (Key Question) The following are hypothetical production possibilities tables for New Zealand and Spain.

New Zealand's production possibilities table (millions of bushels)

Product Production alternatives


Apples 0 20 40 60

Plums 15 10 5 0

Spain's production possibilities table (millions of bushels)

Product Production alternatives


Apples 0 20 40 60

Plums 60 40 20 0

Using a graph, plot the production possibilities data for each of the two countries. Referring to your graphs, determine: (a) Each country's domestic opportunity cost of producing plums and apples. (b) Which nation should specialize in which product. (c) The trading possibilities lines for each nation if the actual terms of trade are 1 plum for 2 apples.

Answers to Key Questions appear in the text.

20-5 "The United States can produce product X more efficiently that can Great Britain. Yet we import X from Great Britain." Explain.

Trade is based on comparative rather than absolute cost advantages. The United States may have an absolute advantage in the production of good X yet still import it from another country because its cost advantage in the production of another good Y is even greater. By producing Y and importing X from Great Britain, Americans are devoting resources to their most productive use, even though an isolated analysis of the international production of X might suggest otherwise.

20-8 "The most valid arguments for tariff protection are also the most easily abused." What are these arguments? Why are they susceptible to abuse? Evaluate the use of artificial trade barriers, such as tariffs and import quotas, as a means of achieving and maintaining full employment.

Trade barriers can be legitimately defended as being necessary to protect domestic firms from foreign dumping, to protect so-called infant industries, and to ensure adequate production levels in sectors deemed to be essential in the event of international hostilities. (The arguments relating to supposed increases in domestic employment, protection from foreign low-wage labor, and economic diversification are either invalid or are irrelevant to the American economy.)

Each of the former arguments, though logically valid, are often misapplied. Proven cases of dumping by foreign firms in the United States are relatively infrequent, and all too often domestic producers will claim their foreign competitors are dumping when their lower prices simply reflect a comparative advantage in production. If this is so, the use of antidumping duties lessens the benefits of free trade.

The protection of new domestic industries in order to allow them to gradually establish efficient production techniques is of questionable legitimacy in the case of an advanced economy such as the United States. There is a tendency for trade barriers to remain in place even after the industry has become established. Moreover, it can be argued that protection provides incentives for "Peter Pan" behavior as firms refuse to mature.

The argument relating to military self-sufficiency is of questionable relevance to sectors other than those directly related to defense. Almost all industries can claim to play a marginal role in a wartime economy. As a rule, direct government subsidies are a more equitable means of financing military security than trade protection, since taxpayers as a whole, rather than just consumers of protected industries will shoulder the burden. Direct subsidies also make the costs of these programs explicit rather than allowing them to be hidden in the form of higher prices.

Trade barriers on imports, by themselves, will cause consumers to partially substitute domestically produced items for imported items, leading to a short-run increase in domestic output and employment in an economy experiencing a recession. These barriers will have several indirect effects, however, which tend to counteract this short-term rise in employment. First, a decrease in imports will lower employment in sectors that use these goods as inputs or are involved in the distribution and sale of these goods. Second, employment and income in other countries will decrease. Not only will the demand for American exports and hence domestic employment automatically decrease as a result, but foreign governments will likely retaliate by imposing trade restrictions of their own, leading to a further decline in exports and employment. These indirect effects severely limit the employment benefits of trade restrictions, and can completely cancel them in the long run. The primary result of trade restrictions will be a reallocation of American and foreign resources to relatively inefficient industries, decreasing national and world output.

20-9 Evaluate the following statements:

(a) "Protective tariffs limit both the imports and the exports of the nation levying tariffs."

(b) "The extensive application of protective tariffs destroys the ability of the international market system to allocate resources efficiently.

(c) "Unemployment can often be reduced through tariff protection, but by the same token inefficiency typically increases."

(d) "Foreign firms which 'dump' their products onto the American market are in effect presenting the American people with gifts."

(e) "In view of the rapidity with which technological advance is dispersed around the world, free trade will inevitably yield structural maladjustments, unemployment, and balance of payments problems for industrially advanced nations."

(f) "Free trade can improve the composition and efficiency of domestic output. Only the Volkswagen forced Detroit to make a compact car, and only foreign success with the oxygen process forced American steel firms to modernize."

(g) "In the long run foreign trade is neutral with respect to total employment."

(a) This statement is true. Protective tariffs increase domestic prices of imported goods, decreasing demand for these products, limiting import volumes, and causing real incomes in producing countries to fall. This decline in incomes will cause foreigners to demand fewer goods and services, including exports from the nation that originally imposed the tariff. Other countries may also retaliate, decreasing export volumes of the tariff-levying nation even further.

(b) This statement is true. Extensive protective tariffs dampen every trading country's ability to export, and since exports ultimately pay for imports, each country's ability to import is hampered as well. As trade flows decrease, countries will be forced to devote scarce resources to the production of goods in which they do not have a comparative advantage, decreasing both world output and real incomes in each nation.

(c) This statement is true. While tariffs directly increase domestic employment in sectors that compete with foreign exporters, there will be indirect employment losses in other sectors. Not only will jobs be lost in the tariff-levying country's own export industries, as incomes and import levels in foreign countries decrease, but also in industries that distribute or use imported goods because of rises in price and unit cost.

(d) This statement is true, at least in the short run. Dumping by foreign firms causes prices in American markets to decline, increasing quantities purchased by domestic consumers and enhancing economic welfare. But lower production in domestic industries will cause a drop in American incomes, decreasing economic welfare, and in the long run, the price wars caused by dumping may force some firms out of the market, restricting competition in domestic markets and allowing foreign firms to raise prices. If this occurs, the welfare of American consumers will decline, and remaining domestic producers will benefit.

(e) This statement is true in the short run. Industrially advanced nations have erected a multitude of trade barriers for manufactured exports from less developed countries, given the cost advantage these countries possess because of their adoption of modern production techniques and the availability of low-wage labor. If these trade barriers were removed, not only would manufactured exports from these countries immediately increase, but entrepreneurs in both industrially advanced and less developed countries would find it profitable to set up additional production facilities in these countries, raising exports even more in the long run. There is no doubt that these low-priced exports would cause short-term harm to manufacturing industries in industrially advanced countries that use predominantly unskilled labor. Output and employment levels in these sectors would fall, and import levels in industrially advanced countries would rise, leading to the possibility of short-run balance of payments deficits in countries maintaining fixed exchange rates. In the long run, however, industrially advanced economies will benefit from free trade, as resources move to sectors in which these countries have a comparative advantage. Moreover, exports to previously less developed countries will increase as output levels and real incomes in these countries rise.

(f) This statement is true. Not only does free trade increase efficiency in the short run by allowing countries to specialize in those products in which they possess a comparative advantage, but by increasing levels of competition and the size of potential markets it acts as a spur to technological innovation and enhanced product quality in the long run.

(g) This statement is true. While changes in levels of foreign trade can cause temporary effects on employment through fluctuations in the net export component of aggregate expenditures, in the long run total employment levels in trading nations are determined by domestic macroeconomic policies and labor-market conditions. Foreign trade, however, has a significant effect on the allocation of labor among various industries in an economy, shifting employment into sectors in which a particular economy has a comparative cost advantage.

20-10 In 1981-1985 the Japanese agreed to a voluntary export restriction which reduced American imports of Japanese automobiles by about 10 percent. What would you expect the short-run effects to have been on the American and Japanese automobile industries? If this restriction were permanent, what would be its long-run effects in the two nations on (a) the allocation of resources, (b) the volume of employment, (c) the price level, and (d) the standard of living?

In the short run, the limitation on imported Japanese automobiles would cause a domestic shortage of these items. Japanese companies can respond to this shortage in two ways. They can maintain prices at current levels and ration sales through delivery delays, or they can increase prices for their products in the American market. The latter response will cause a long-term decrease in the firms' American market shares, but the longer the import limitations are in effect the more probable it becomes, since the increase in unit profits that results from higher prices will partly counteract the effects of sales losses.

No matter which policy is followed, some prospective purchasers will shift their demand to other goods, including domestically produced automobiles. Profits for American producers will rise either through increases in sales or in price.

(a) Resource allocation will be made less efficient in both the United States and Japan. American automobile firms will be devoting scarce resources to the production of units in which they do not have a comparative advantage. As for Japan, decreased exports will lead to a fall in imports in the long run, and resources will be moved to sectors in which Japan's comparative advantage is less.

(b) Employment in each country will not change appreciably in the long run, although there could be a temporary increase in American employment as automobile production rises and a corresponding decrease in Japan as production declines.

(c) Automobile prices in the United States will rise in the long run, boosting the general price level. Other prices will rise as costs for car-using firms increase and American consumers purchase fewer automobiles and more of other goods and services. The decrease in Japanese exports to the United States, meanwhile, will cause a drop in the supply of American dollars being exchanged for yen, leading to an appreciation of the yen price of the dollar (see Chapter 21). Prices of American imports in Japan therefore rise. Other Japanese prices increase as costs for import-using firms rise and consumers shift spending to other products.

(d) Because voluntary quotas decrease trade flows between the United States and Japan, some of the benefits arising from specialization will be lost, decreasing total output and real incomes in both countries.

20-11 (Key Question) What are the benefits and the costs of protectionist policies? Which are larger?

Answers to Key Questions appear in the text.

20-12 What are NAFTA and GATT and how do they relate to international trade? What policies has the United States government recently used to promote American exports? What factors make it difficult for American firms to sell their goods in Japan? What actions do you think the United States should take to reduce America's trade deficit with Japan?

NAFTA and GATT are trade agreements aimed at reducing trade restrictions among the nations signing the agreements. NAFTA is the North American Free Trade Agreement for the United States, Canada, and Mexico. GATT is a world trade agreement signed by more than 120 nations. By promoting free trade among nations, these agreements should expand world trade and production.

The U.S. has recently used several policies to promote exports. Included have been direct government advocacy of export interests around the world, relaxation of export controls, increased loans to foreign purchasers of U.S. products through the government's Export-Import Bank, and some use of retaliatory measures or threats where countries have trade barriers against U.S. exports.

The U.S.-Japan trade deficit is a difficult problem to solve because Japanese consumers already buy on average more U.S. goods per capita than Americans buy from the Japanese. However, due to the larger U.S. population, it is natural that our imports from them might exceed their imports from us. There is a widespread system of nontariff trade barriers, which impedes imports into Japan. These could be reduced and are the target of bilateral negotiations. Also, Japan's system of keiretsu --large groups of interlocked Japanese firms that buy and sell exclusively to one another-- make it hard for U.S. producers to break into Japanese markets. Elimination of tariffs and nontariff barriers will be a step toward reducing the deficit, but it will not cause it to disappear as long as U.S. consumers desire to purchase Japanese products at the present rate. Some of the trade deficit may also be reduced as a consequence of shifting exchange rates, which have made Japanese goods more costly for American purchasers and American products less expensive for Japanese purchasers. The final effects of this drop in the value of the U.S. dollar relative to the Japanese yen in recent years remain to be seen.

20-13 (Last Word) What point is Bastiat trying to make with his petition of the candlemakers?

He is providing an exaggerated example of protectionism to illustrate the point that trade restrictions may help a few producers, but they serve to reduce the overall standard of living. How ridiculous it would be to eliminate natural sunlight in order to protect the makers of products that provide artificial light.

pp. 448-9 11, 12, 13

2111 Some people assert that the United States is facing a foreign trade crisis? What do you think they mean? What are the major causes of this "crisis"?

In the 1980s and the first half of the 1990s, imports far outstripped exports in the American economy, leading to continued nominal trade deficits. This trade imbalance caused the current account to move from a slight surplus to a large deficit during the same period.

This socalled crisis was partially attributable to domestic macroeconomic policy. During the first part of this period, the Federal Reserve was following a tight monetary policy in order to decrease inflation while Federal budget deficits increased throughout the period. Both policies, while contradictory in terms of their effects on employment and inflation, caused real interest rates in the United States to rise, and the success of the tight monetary policy in pushing down inflation rates increased real rates of interest even further. The rise in real interest rates stimulated financial investment in the United States, raising the foreign value of the American dollar. Using a tradeweighted index of ten major foreign currencies, the dollar rose by over 60 percent between 1980 and 1985. This rise in the foreign exchange rate caused the foreign demand for American goods and services to fall and the American demand for foreign products to increase.

The second cause of this trade imbalance was also indirectly related to macroeconomic policy. Partly because of expansionary fiscal policy, American growth rates during the early 1980s were much higher than those of its major trading partners. With American real incomes expanding more rapidly than in other countries, American imports rose at a quicker rate than exports. This pattern was repeated in the 1992-1994 period.

A related cause is our stubborn trade deficit with Japan (see Global Perspective 20-1). Thus far this deficit has not declined as fast as the dollar has depreciated against the yen. Japanese firms have resisted increasing their dollar prices on exports by the same percentage as the decline in the value of the dollar and have accepted a lower profit margin on products sent to the U.S.

2112 Cite and explain two reasons for the decline in the value of the American dollar between 1985 and 1987. Why did the U.S. trade deficit remain high, even though the dollar fell in value?

The decline in the foreign value of the American dollar between 1985 and 1987 is attributable to two factors. First, representatives of the five major (noncommunist) industrial nations agreed in 1985 to gradually force down the dollar's value by increasing the supply of dollars on foreign exchange markets. Second, the growth of American imports had become so significant that its effect on the supply of American dollars in foreign exchange markets began to outweigh the appreciation caused by high American real interest rates.

While American exports soon increased after the decline in the dollar's international value, as theory would suggest, import volumes continued to grow. This seeming anomaly was caused both by a willingness of many foreign companies to accept lower profit margins on goods sold in the United States and a lag between changes in import prices and shifts in American consumption patterns. It was not until 1987 that the growth of imports finally dropped below export growth, causing a decline in the merchandise trade deficit.

2113 (Key Question) Explain how a reduction in the Federal budget deficit could contribute to a decline in the U.S. trade deficit. Why do trade deficits fall during recessions? Is recession a desirable remedy to trade deficits?

Answers to Key Questions appear in the text.

Ch. 23: p. 487 1, 2, 3, 4, 5, 6, 7, 8, 11

231 Compare the ideology and institutional framework of the former Soviet economy with that of American capitalism. Contrast the manner in which production was motivated in the Soviet Union compared to how it is motivated in the United States.

The ideology of the former Soviet economy was based on the theories of Karl Marx and the first Soviet leader, Vladimir Lenin. They envisioned their system as a successor to capitalism, which they believed was doomed to collapse. Markets were chaotic, unstable, and worst of all were inequitable as capitalists exploited workers. Their ideology expressed that capitalists had no choice but to exploit the workers they hired, and workers had no choice but to be exploited because the capitalists owned the means of production. This would all change when a workers' state took over these means of production. Under capitalist ideology, markets are not chaotic but lead to equilibrium prices and quantities that will maximize consumer satisfaction. Workers and entrepreneurs alike behave according to their own self-interest, but this greed is tempered by competition, which forces them to produce what consumers want at the lowest possible price, using the most efficient combination of resources.

The former Soviet state, as the selfstyled vanguard of the proletariat, owned all enterprises and physical resources in the country, with several exceptions. These included collective enterprises and private agricultural production that was allowed on small plots set aside for this purpose (although all land is stateowned); durable goods used by households; and some housing, especially in rural areas. All economic activity in the Soviet Union, except for that carried on by collectives and private agricultural producers, was subject to a complex system of central economic planning. Hence, the Soviet Union represented for all intents and purposes a command economy. In contrast, the United States is a largely capitalist economy characterized by the private ownership of resources and the use of decentralized markets to direct and coordinate most economic activity. Government involvement, while significant, is restricted to areas in which private markets are deemed to be inefficient or unworkable.

In the United States, it is consumer preferences communicated through the mechanism of private markets that determine the nature of production and resource allocation. In the former Soviet Union, it was government decisions communicated through the mechanism of central plans that motivated production and determined the allocation of scarce resources --at least as far as legally sanctioned economic activity was concerned.

While the transition has far to go, the current Russian economy is moving toward a private market economy, which will resemble that of the United States eventually. In this system, the state will gradually extract itself from production of most goods and services, and rather than a planned economy, market supply and demand will be the primary forces determining what is produced, how it is produced, and what price will be charged for each good or service.

232 Discuss the problem of coordination which faced central planners in the former Soviet Union. Explain how a planning failure can cause a chain reaction of additional failures.

Planners must not only set output targets for each industry and enterprise, but they must allocate inputs to each of these enterprises so that their output targets can be met. Because the outputs of many industries are inputs to other industries, the failure of any single industry to fulfill its plan is likely to cause a whole chain of adverse repercussions. For example, if the iron mines fail to supply the steel industry with enough iron, then the steel industry will not be able to supply steelusing industries, such as automobiles, tractors, and transportation, with their needed inputs. Bottlenecks are thus created in many related industries. In a market system, prices would rise to provide incentives to break such bottlenecks, but in a planned economy, price incentives exist only outside the official system.

233 How was the number of automobiles to be produced determined in the former Soviet Union? In the United States? How are the decisions implemented in the two different types of economies?

In the former Soviet Union the number of automobiles produced was determined by planning authorities. General production targets were included in a fiveyear plan, with more specific targets in oneyear plans on the basis of priority ratings for this sector. Actual production was then carried out with the supervision of the State Bank (Gosbank), which provided necessary financial credits to staterun enterprises. Necessary inputs to produce the planned output were allocated by the planning authorities to the auto industry.

In the United States, the number of automobiles is determined by the interaction of demand and supply. Presuming that the outcome in the automobile sector is close to equilibrium in a competitive market (presence of foreign producers makes the auto industry quite competitive), the output of automobiles will be such that the marginal benefits of consumption will equal the marginal costs of production. Automobile production is implemented through the workings of the market and its profit incentive. At an output level other than the equilibrium level, firms will find it profitable to contract or expand production.

While the decisionmaking process is very different in the two economies, the implementation process is more similar. In both systems, plant managers will implement the production decisions of the decision makers. However, in the capitalist system, the manager has authority with respect to hiring and ordering of inputs, depending on the prices of alternative resource supplies. At the retail level, the seller has a large degree of independence with regard to pricing the automobile. In the former Soviet system, the planners would determine the retail price as well as the number and type of inputs without much regard to the price of those inputs.

234 What were the major characteristics and goals of Soviet central planning?

The major characteristics included the following: (1) rapid industrialization and military buildup with less emphasis on consumer and service sectors and the infrastructure; (2) overcommitment of resources so that not all production targets could be achieved; (3) mobilization of resources, especially labor, by coercion if necessary; (4) resource allocation by directives; (5) governmentally determined prices of inputs and outputs; (6) selfsufficiency without reliance on international trade; and (7) passive macroeconomic policies, since prices and money played only a limited role.

The goals of the planners were to provide fullemployment and income security for Soviet citizens with basic social services available to all; to achieve an educated population able to deal with modern technology; to achieve equity according to Marxist ideals; and to achieve selfsufficiency without reliance on the "capitalist imperialists." Central planning was to replace reliance on capitalists who would exploit workers, according to Marxist theory.

235 What was the evidence of the failure of Soviet planning? Explain why Soviet economic growth diminished after 1970.

Evidence of the failure of Soviet planning included the slowdown in the rate of economic growth in the 1970s and 1980s to the actual decline in economic output in the 1990s; the quality of goods had deteriorated far below international standards; there were shortages of many goods and services and a lack of variety, which led to long lines, black markets, and corruption in distribution of products. Comparisons with the United States included a few startling statistics, such as the fact that in 1988 there were 555 cars per 1000 people in the U.S. but only 42 cars per 1000 people in the Soviet Union; just over onetenth of the Soviet population had a phone, while there were 501 phones per 1000 people in the United States; overall, the Soviet level of per capita consumption was estimated to be no more than 30 percent that of the U.S., and this may have been an overestimate.

Causes of the failure included the burden of high military spending (about 1520 percent of GDP compared to 6 percent in the U.S.); low productivity and large proportion of labor force engaged in agriculture; former reliance on expanding the resource base to expand economic growth. But as resources became less abundant, growth had to arise from increased efficiency which had been a problem in socialist economies. The increased complexity of the modern industrial economy also made planning more difficult; there was difficulty in finding adequate success indicators; and there were weak incentives for innovation, improving efficiency, and fulfilling the plan.

236 Explain why the use of quantitative output targets as the major success indicator for Soviet enterprises contributed to economic inefficiency.

Quantitative output targets emphasize maximizing output without regard to efficiency in the use of inputs. If rewards are based on meeting quantitative targets, the incentives will be focused on achieving those targets in the easiest way, which is to obtain the maximum amount of inputs possible. Thus, rather than conserving on inputs, managers in Soviet enterprises were motivated to overestimate the amount of inputs needed to help insure the availability of inputs and the achievement of output targets. In such a system, there is no reward, hence no reason, for producing goods efficiently. Furthermore, since quality and innovation were not rewarded, these aspects of production were neglected.

237 (Key Question) Use a supply and demand diagram to explain why persistent shortages of many Soviet consumer goods occurred in the former Soviet Union. Why has the transformation to a market economy been accompanied by inflation? Why were black markets so common in the Soviet Union?

Answers to Key Questions appear in the text.

238 (Key Question) What specific changes must be made to transform the Soviet economy to a market system? Why is it important that these changes be introduced simultaneously?

Answers to Key Questions appear in the text.

23-11 (Last Word) In what specific respects have Chinese economic reforms differed from Russia's? Do you believe these differences account for China's superior growth?

China, relative to Russia, has proceeded more gradually and for a longer period of time with its reforms, which date to 1978; political reform has not accompanied economic reform in China while it has in Russia; while Russia has tried to privatize its state-owned enterprises, China has allowed them to remain and encouraged the creation of competing private enterprises; Russia has sought to integrate itself quickly into the world economy, while China has established only certain regions designated as "special economic zones" for foreign trade and investment, to break the government's monopoly on foreign trade and finance.

These differences certainly account for much of the difference in growth rates. But, it may be too early to pass judgment on the success or failure of Russian reforms since they began much later. However, political stability in China, coupled with a burgeoning private sector that provides competition to the state sector, have provided ingredients of success that have been missing in the Russian case.