Macroeconomics, Fourteenth Canadian Edition Solution Manual

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’SMANUALChristopher T. S. RaganEconomicsFourteenth Canadian EditionChristopher T. S. RaganMcGill UniversitySolution Manual

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iii___________________Table of Contents___________________PrefacevPart One: What Is Economics?1Chapter 1: Economic Issues and Concepts3Chapter 2: Economic Theories, Data, and Graphs12Part Two: An Introduction to Demand and Supply24Chapter 3: Demand, Supply, and Price25Chapter 4: Elasticity34Chapter 5: Markets in Action46Part Three: Consumers and Producers56Chapter 6: Consumer Behaviour57Chapter 7: Producers in the Short Run68Chapter 8: Producers in the Long Run78Part Four: Market Structure and Efficiency88Chapter 9: Competitive Markets90Chapter 10: Monopoly, Cartels, and Price Discrimination100Chapter 11: Imperfect Competition and Strategic Behaviour110Chapter 12: Economic Efficiency and Public Policy120Part Five: Factor Markets130Chapter 13: How Factor Markets Work132Chapter 14: Labour Markets142Chapter 15: Interest Rates and the Capital Market152Part Six: Government in the Market Economy160Chapter 16: Market Failures and Government Intervention162Chapter 17: The Economics of Environmental Protection174Chapter 18: Taxation and Public Expenditure182Part Seven: An Introduction to Macroeconomics192Chapter 19: What Macroeconomics Is All About193Chapter 20: The Measurement of National Income200

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ivPart Eight: The Economy in the Short Run208Chapter 21: The Simplest Short-Run Macro Model210Chapter 22: Adding Government and Trade to the Simple Macro Model220Chapter 23: Output and Prices in the Short Run230Part Nine: The Economy in the Long Run240Chapter 24: From the Short Run to the Long Run: The Adjustmentof Factor Prices242Chapter 25: The Difference Between Short-Run and Long-RunMacroeconomics252Chapter 26: Long-Run Economic Growth260Part Ten: Money, Banking, and Monetary Policy270Chapter 27: Money and Banking272Chapter 28: Money, Interest Rates, and Economic Activity280Chapter 29: Monetary Policy in Canada288Part Eleven: Macroeconomic Problems and Policies296Chapter 30: Inflation and Disinflation297Chapter 31: Unemployment Fluctuations and the NAIRU306Chapter 32: Government Debt and Deficits316Part Twelve: Canada in the Global Economy324Chapter 33: The Gains from International Trade325Chapter 34: Trade Policy334Chapter 35: Exchange Rates and the Balance of Payments342

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v__________Preface__________ThisManualserves several functions. For instructors, it provides some help instaying ahead of the many burdens that a full teaching load imposes. For the author itprovides an opportunity to talk directly to the teachers––to let you know what we had inmind, why we did some things differently in this edition (or in some cases differently thanother books do them), and to share with you some of our experiences with teaching thematerial.1Our general philosophy and approach are discussed in the Preface to our text, asare the major revisions in this fourteenth edition ofEconomics.TheStudy Exercisesat the end of each chapter are designed for the student to workthrough on their own. These questions will give them practice drawing graphs, shiftingcurves, computing elasticities, calculating multipliers, thinking through the predicted effectsof various economic “shocks”, and so on. Even if you use a multiple-choice exam to test yourstudents, they will surely benefit by going through these exercises. Providing our “model”answers to these questions is one of the most important features of this’s Manual.The full answers to theStudy Exercises, complete with graphs where appropriate, areprovided. Note that we have also provided answers to the redStudy Exerciseson thetextbook’s accompanying onlineMyEconLab. Please let your students know this.Finally, we have a simple request. If our book becomes more teachable from editionto edition, as we believe it does, much of the credit goes to teachers who call our attention toerrors, omissions, difficulties in exposition, ambiguities, or organizational flaws. While wedo not adopt every suggestion, we consider each carefully and act on a large fraction. If youhave any suggestions, please write us so we can continue to incorporate your ideas forimprovements. Please send your comments by email to:christopher.ragan@mcgill.ca.We look forward to receiving your comments. Good teaching!Christopher RaganMcGill University1After thirteen editions with multiple co-authors on this textbook, the author list now displays a single name.The first-personpluralis still used throughout this’s Manual, however. Partly this is because itsounds less personal and less jarring, and partly it is to reflect the writing and pedagogical decisions that havebeen made over the years by the broader collection of authors, many of which remain in the current edition.

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Part 1: What Is Economics?1_______________________________________Part OneWhat Is Economics?________________________________________This opening Part of the book provides an introduction to economics. The central themes ofChapter 1 are scarcity, choice, opportunity cost, and the self-organizing role of markets. The chapteralsoexaminesthegainsfromspecializationandtrade,theroleofmoney,theeffectsofglobalization, and ends with a discussion of the various types of economic systems. An appendix toChapter 1 provides students with a brief refresher on basic graphing techniques. Chapter 2examines how economists organize their thoughts, build their models, and test their theories. It alsoaddresses central methodological issues, the most important being the idea that the progress ofeconomics depends on relating our theories to what we observe in the world around us. Finally, thechapter has an extensive section on graphs and graphing.***Chapter 1 opens with a brief tour of some key economic issues in Canada and other countries—from government debt and climate change to population aging and productivity growth. Thepurpose is to whet the reader’s appetite for the kinds of issues that economists are thinking abouttoday. This offers a natural segue to the discussion of scarcity, for without the presence of scarcityfew of these issues would be very interesting. The chapter then addresses the fundamental conceptsof scarcity, choice, and opportunity cost, illustrating these ideas with a production possibilitiesboundary. (It is worth noting that these concepts are relevant toalleconomies, no matter how theyare organized—central planning or free markets.) We then examine the complexity of modernmarket economies, examining the decision makers, production, trade, money, and globalization.Finally, we examine different types of economic systems, including traditional, command, and free-market systems. We emphasize that all actual economies are mixtures, containing elements of allthree pure systems.Chapter 2 provides a longer introduction to the methodological issues of economics than isusually included in introductory texts. We do this because most students believe that the scientificmethod is limited to the natural sciences. But to appreciate economics, they must understand that itstheories are also open to empirical testing and that these theories continually change as a result ofwhat the empirical evidence shows. We understand that some instructors feel their time is solimited that they cannot spend class time on Chapter 2. We believe that even if it is not covered inclass, students’ attention should be called to the issues addressed in the chapter. Our experience isthat students benefit from some discussion of the scientific method and from the insight that the

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2Part 1: What Is Economics?social sciences are not all that different from the “hard” sciences, at least in their basic approaches.The chapter begins by making the distinction between positive and normative statements.We then work carefully through the various elements of economic theories, including definitions,assumptions, and predictions. Testing theories is as important as developing them, so we emphasizethe interaction between theorizing and empirical observation. We then present various types ofeconomic data, and this gets us into a detailed discussion of index numbers, time-series and cross-section data, and graphs. The final section of the chapter goes through graphing in detail.

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Chapter 1: Economic Issues and Concepts3_______________________________________Chapter 1: Economic Issues and Concepts_______________________________________This chapter is in three main sections, after a short introductory mention of some keyeconomic issues of the day. The first substantive section develops the concepts of scarcity, choice,and opportunity cost. To ensure the student really understands what opportunity cost is all about, wehave a box that examines the opportunity cost of a college degree. This should be a familiarexample to which students can easily relate. The production possibilities boundary is thenintroduced, and it is shown to embody the three key concepts of scarcity, choice and opportunitycost. Its nature as a frontier between the attainable and the unattainable is worth stressing, as is thefact that what is attainable is itself subject to change. Four key economic problems are thendiscussed, and each one is expressed in terms of the production possibilities boundary. Thesequestions give the student an inkling of the types of questions addressed both in microeconomicsand in macroeconomics.The chapter’s second section examines the complexity of modern economies, asking why itis that the things we want to purchase are almost always available. What produces this remarkablecoordination? We discuss the market as an instrument that brings order to the economy as a whole.Along the way, the student is introduced to Adam Smith’s “invisible hand”. The section alsodiscusses who makes the choices in a market economy, and why incentives matter. We show thecircular flow of income and expenditure as a way of showing the interaction between consumersand producers. We also examine the nature of maximizing decisions (both utility and profit), andthe importance of decisions at the margin. Finally, on the production side, we examine the role ofspecialization, the division of labour, globalization, and the importance of money in facilitatingtrade.The chapter’s third and final section deals with comparative economic systems. Studentswill read in almost every chapter of this book about a market economy. Contrasting it with plannedand traditional economies is a good way to gain some insight into the concept at the outset. Weemphasize that actual economies are rarely, if ever, well represented by the extremes; instead,actual economies are mixed economies, with varying degrees of government ownership andplanning. Students are introduced to Karl Marx’s argument for a centrally planned economy. WhileMarx had many things right, we argue that central planning has not been successful in proving itselfas an efficient way of organizing an economy, allocating resources, or generating prosperity for alarge fraction of the population. This discussion leads to a box on the failure of central planning inthe former Soviet Union.

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4Chapter 1: Economic Issues and ConceptsAnswers to Study ExercisesQuestion 1a.land, labour, capital; factorsb.opportunity costc.production possibilities boundaryd.scarcity (because points outside the boundary are unattainable); downward (or negative);the opportunity cost associated with any choicee.constant; increasingf.increases (meaning that more units of good B must be given up to get an extra unit ofgood A)Question 2Any realistic production possibilities boundary displays scarcity, the need for choice, andopportunity cost.Scarcity:The production possibilities boundary (PPB) separates attainable combinations ofgoods from those that are unattainable. Thus scarcity is shown by the existence of someunattainable bundles of goods.Choice:Because of scarcity, societies must somehow choose how resources are to be allocated;thus a particular point on the PPB must be chosen.Opportunity Cost:The slope of the PPB is negative, revealing the opportunity cost that isunavoidable every time a choice is made. For the economy as a whole, the decision to producemore of one good must involve a decision to produce less of some other good.Question 3a) At point A, 2.5 tonnes of clothing and 3 tonnes of food are being produced per year. At pointB, annual production is 2.5 tonnes of clothing and 7 tonnes of food. At point C, annualproduction is 6.5 tonnes of clothing and 3 tonnes of food.b) At point A the economy is either using its resources inefficiently or it is not using all of itsavailable resources. Point B and C represent full and efficient use of available resources becausethey are on the PPB.c) At point B, the opportunity cost of producing one more tonne of food (and increase from 7 to8) is the 2.5 tonnes of clothing that must be given up. The opportunity cost of producing onemore tonne of clothing (from 2.5 to 3.5) appears, from the graph, to be approximately 0.75

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Chapter 1: Economic Issues and Concepts5tonnes of food that must be given up.d) Point D is unattainable given the economy’s current technology and resources. Point D canbecome attainable with a sufficient improvement in technology or increase in available resources.Question 4a) As the table shows, there are only 250 workers in Choiceland, and to construct the productionpossibilities boundary we must imagine all the combinations of workers in each sector. Using thetwo middle columns from the table, we can plot the output levels on a graph to get the following:b) If the economy is already producing 45 units of X and 900 units of Y, then 15 extra units of Xcan only be produced by reducing the production of Y by 300 units. The opportunity cost of 15units of X is therefore 300 units of Y (or 300/15 = 20 units of Y per unit of X). If the economy isalready producing 60 units of X (and 600 units of Y), the opportunity cost of producing anadditional 15 units of X is the full 600 units of Y that must be given up. This implies anopportunity cost of 600/15 = 40 units of Y per extra unit of X. Thus, we see that the opportunitycost of X rises when more of X is already being produced.c) If the economy is producing 40 units of X and 600 units of Y, then either some resources arenot being used or they are being used inefficiently; the economy is operatinginsidetheproduction possibilities boundary. It would thus be possible to improve the use of resources andincrease output of X by 20 units without reducing the output of Y at all. In this sense, the extraoutput of X has no opportunity cost in terms of forgone units of Y.d) If any given amount of labour can now produce 10 percent more of good Y, then the PPBshifts up in a particular way. Specifically, the Y values increase by 10 percent for any given Xvalue, as shown below.

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6Chapter 1: Economic Issues and ConceptsQuestion 5The diagram in part (d) of Question 4 shows immediately why a technological improvement inone industry means that a country can now choose to produce more ofbothgoods. Since the PPBhas shifted up (or out), there are many combinations of goods that are now available that werenot before, and some of these involve producing more of both goods. For example, if theeconomy was initially producing 45 units of X and 900 units of Y (see point A), it could nowproduce more than 45 units of X and more than 900 units of Y, such as at point B. This changewould require shifting some resources away from sector Y and toward sector X.Question 6In general, the opportunity cost (measured in dollars) for any activity includes three things:•the direct (dollar) cost of the activity, plus•the dollar value of whatever you give up in order to do the activity, minus•whatever dollar “savings” the activity generatesIn this case, the direct cost of transportation, lift tickets and accommodation of $300 is definitelyincluded. The income of $120 that you give up also counts. Finally, we must deal with therestaurant meals of $75. Surely you would have eatensomefood even if you hadn’t gone skiing,so the full $75 is not included. But given the relatively high price of restaurant meals comparedto buying your own groceries, you will probably include most of the $75. Thus the opportunitycost of the ski trip is $420 plus some (large) fraction of the $75.

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Chapter 1: Economic Issues and Concepts7Question 7This question is good for forcing students to think through the computation of opportunity costand also in showing how the allocation of labour in particular ways can maximize total output.a) You can catch 6 fish or collect 3 bundles of firewood in one day’s work. Thus, youropportunity cost for one additional bundle of firewood is 2 fish. For your friend, the opportunitycost of one additional bundle of firewood is 4 fish.b) To allocate tasks in the output-maximizing way, each person should do the task for which theyhave the lower opportunity cost. You have the lower opportunity cost of collecting firewood.Your friend has the lower opportunity cost for catching fish (0.25 of a bundle for your friend ascompared to 0.5 of a bundle for you). So for the two of you to collectively maximize output youshould specialize in collecting firewood and your friend should specialize in catching fish.c) What is the total amount of output after two days, if you allocate labour as in part (b)? In twodays, you would collect 6 bundles of firewood and your friend would catch 16 fish. The reversepattern of specialization would yield only 4 bundles of firewood and 12 fish, which is clearlyinferior.Question 8The central ideas illustrated by the two-good version of the production possibilities boundary (PPB)are scarcity, choice, and opportunity cost. Exactly the same ideas can be illustrated in a morerealistic three-good version of the model, which is more complicated to draw, or by the much morerealistic N-good version of the model (with N≥4), which is impossible to draw. Thus theassumption of only two goods is merely a simplifying one: it allows us to easily grasp and illustratesome central points that would be more difficult to understand in the more general N-good case.Question 9Microeconomicsis the study of the allocation of resources within and across individual markets,and the determination of relative prices and quantities in those specific markets. Little or noattention is paid to the behaviour of the aggregate economy.Macroeconomicsis the study of thedeterminationofaggregatessuchasaggregateoutput,employment,thepricelevel,theunemployment rate, and the exchange rate. When doing macroeconomics, little or no attention ispaid to what is going on in the individual markets for specific products.Question 10In the answers that follow, note that the statements are madeceteris paribus. In other words, the

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8Chapter 1: Economic Issues and Conceptspredicted result of a change in some specific price is made under the assumption that nothing elsechanges.a) As the price of ski-lift tickets rises, you are likely to substitute toward other leisure activities(whose price has not increased) and thus reduce your purchases of ski-lift tickets.b) As the hourly wage for your weekend job rises, the opportunity cost ofnotworking rises. Soyou are more likely than before to decide not to go skiing, and to work instead.c) As the value of speeding tickets rises, the cost of being caught speeding clearly increases. Thebenefit of driving over the speed limit is presumably unchanged, however. So an increase in thevalue of speeding tickets is likely to cause you to reduce your speed (and to watch more carefullyfor hidden police cars!).d) If there is a low weight attached to an assignment, there is less of an incentive for you to workhard on it because the cost of not working hard (and receiving a low grade) is small. So thehigher the weight placed on the assignment, the harder you are expected to work on it. (This isone obvious reason why professors like to put significant weight on midterm exams – to getstudents to work hard early in the course rather than leaving all the work to the few days beforethe final exam!)e) As tuition fees for one specific institution increase, you are likely to substitute toward otherinstitutions whose fees have not increased, and thus reduce your desire to attend the firstinstitution. (For small changes in tuition fees, this effect may be very small because of theperceived large differences between some educational institutions.)Question 11There are two reasons why the specialization of labour is more efficient than self-sufficiency.First, since individual abilities differ, specializing allows each person to focus their energies onwhat they do best, leaving everything else to be done by others. As a result, total output will rise.Second, as people specialize, they often “learn by doing” and become even better at their specifictask. Thus specialization often leads to improvements in ability that would not otherwise occur.Question 12The market for doctors’ services depends heavily on the specialization of labour. A person withback pain will not know what is wrong. They go to a general practitioner (GP) who is somewhatfamiliar with a broad range of symptoms and illnesses. The GP may rule out the simplestpossible causes for the pain, and in the process determine that the patient requires the services ofa specialist who diagnoses and treats the patient’s back. The patient is referred to this specialistwho may diagnose a ruptured disk and perform the delicate surgery necessary to solve theproblem. Given this reliance on specialization, the market depends on having relatively more

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Chapter 1: Economic Issues and Concepts9GPs who see a large number of patients and act as “gatekeepers” for patients to the more specificspecialists.Question 13Traditional systems:Behaviour is based primarily on tradition, custom, and habit.Command systems:Decisions about production and consumption are determined by a centralplanning authority.Free-marketsystems:Productionandconsumptiondecisionsaremadeprivately,bydecentralized producers and consumers.Mixed systems:Theseeconomic systems contain elements of tradition, command, and freemarkets.Question 14a) If all Canadian families had the current average income of about $75,000, it would be difficultto say that real poverty existed in Canada. At this level of income, all families would easily haveenough income to provide the essentials of food, shelter, and clothing, and could also have muchbeyond these essentials. However, there would still be many things that these families could notafford, such as expensive university education, expensive vacations, a cottage in the country, etc.Defining poverty with any precision is difficult, and we will say more about this in Chapter 18.b) Would scarcity exist in such a setting? Yes, certainly. By scarcity we mean simply an excessof wants over the resources available to satisfy those wants. And scarcity would exist for each ofthose families because most if not all of them would still desire to have more than they actuallyhad.c) Scarcity is an excess of wants over the resources available to satisfy those wants. Poverty isconcerned with a level of resources below some threshold of sufficiency. One can conceivablyeliminate poverty, as in part (a), but that would not eliminate scarcity.

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10Chapter 1: Economic Issues and ConceptsQuestion 15This quote, if put to a group of students, would stimulate much interesting discussion, not onlyabout views on how alternative economic systems work, but also about the words used to describethem. The termplanned economy, for example, describes the conscious use of centralized decisionmaking for key economic decisions, but theresultsof that process often look anything but planned,with shortages in some sectors, surpluses in others, and often a rather dispirited and unmotivatedprivate sector. On the other hand, theunplanneddecentralized market economy––though surely notperfect––creates a much more orderly looking set of outcomes.*****

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12Chapter 2: Economic Theories, Data, and Graphs______________________________________________Chapter 2: Economic Theories, Data, and Graphs______________________________________________This chapter provides an introduction to the methods that economists use in their research. Weintegrate a detailed discussion of graphing into our discussion of how economists present economicdata and how they test economic theories.In our experience, students typically do not learn enough about the connection betweentheory and evidence, and how both are central to understanding economic phenomena. Wetherefore recommend that considerable emphasis be placed on Figure 2-1, illustrating the processof going from model building to generating hypotheses to confronting data and testing hypotheses,and then returning to model building (or rebuilding). There is no real beginning or end to thisprocess, so it is difficult to call economics an entirely “theory driven” or “data driven” discipline.Without the theory and models, we don’t know what to look for in the data; but withoutexperiencing the world around us, we can’t build models of human behaviour and interactionthrough markets. The scientific approach in economics, as in the “hard” sciences, involves a closerelationship between theory and evidence.***The chapter is divided into four major sections. In the first section, we make the importantdistinction between positive and normative statements and advice. Students must understand thisdistinction, and that the progress of any scientific discipline relies on researchers’ ability toseparate what evidence suggests is true from what they would like to be true. We conclude thissection by explaining why economists are often seen to disagree even though there is a great dealof agreement among them on many specific issues. We have added a new box on whereeconomists typically get jobs and the kind of work they often do.The second section explains the elements of economic theories and how they are tested.We emphasise how a theory’s or model’s definitions and assumptions lead, through a process oflogical deduction, to a set of conditional predictions. We then examine the testing of theories. Itis here that we focus on the interaction of theory and empirical observation (Figure 2-1). Weexamine briefly several aspects of statistical analysis, including the difference between rejectionand confirmation, and the even more crucial distinction between correlation and causation.The chapter’s third section deals with economic data. We begin by explaining theconstruction of index numbers, and we use them to compare the volatility of two sample timeseries. Index numbers are so pervasive in discussions of economic magnitudes that students mustknow what these are and how they are constructed. We then make the distinction between cross-sectional and time-series data, and at this point students are introduced to two types of graph.

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