Answers to Review Questions

Chapters 13-14

Extra Stuff . . Chapter 13 . . Chapter 14

Answers to questions as they were in July, 2006

Chapter 13 The Government and Economic Efficiency

Exploring Public and Private Interest

1. Suppose that you are a head of a large government agency. The legislature wants to cut your budget and you do not want it cut. They ask for proposals on how you could cut spending by 10%. What should you do: try to find the least useful things your agency does, or propose cutting the most valuable things your agency does? Explain the rationale for each strategy.
Cutting the most valuable things puts pressure on the legislature to restore your funding.

2. Congressman Snaggle helps 500 of his constituents each year get checks from the government to which they are legally entitled, but which have gotten lost in the bureaucracy. These people are very grateful to Congressman Snaggle and express this gratitude on election day. Dr. Gutnews, a respected efficiency expert, has figured out a way to eliminate the bureaucratic delays that make these 500 seek Congressman Snaggle's help each year. True or False: Congressman Snaggle will be an enthusiastic supporter of this reform measure because it will help his constituents.
The congressman may lose by having the bureaucracy more efficient. If he does, he will not be an enthusiastic supporter, unless there are plenty of other opportunities for him to help his constituents.

3. Taxes and subsidies are not the only things that can be shifted. An interesting case of shifting occurred with slavery. Draw supply and demand curves for cotton. Now, suppose that slavery is introduced and that slavery is productive. What will this do to the graph that you have drawn? What will happen to the sizes of the consumers' and producers' surpluses? What do you conclude about the primary beneficiaries of slavery?
Slavery probably shifted the supply curve for cotton to the right, lowering price and increasing quantity. The consumers' surplus increased. Much of that surplus was obtained by people in Europe. England was very tempted to enter the U.S. Civil War on the side of the South.

4. Gambling was once illegal throughout most of the United States. In the past fifty years, however, state governments have become major proponents and sponsors of gambling, with most states running lotteries. These lotteries are played primarily by the poor and ignorant. For every dollar bet, roughly 60 cents is paid back to participants, a rate far lower than that paid in most casino games. Does the popularity of state lotteries, given their very poor payout rate, show that people are acting irrationally?

I do not understand the attraction of gambling, so your answer may be as good as mine.

5. The lottery can be viewed as a tax because it is a way for the government to raise money. One of its great attractions is that it is voluntary, unlike traditional taxes. What is its greatest drawback? (Hint: who plays?)

The poor are the dominant players, so gambling is highly regressive. Should the government raise its revenues by preying on the poor and ignorant?

6. The topic of rent seeking has some interesting things to say about the efficiency of theft. It may seem shocking, but at first glance, there is no economic cost to theft. If, for example, a thief steals $1000 from you, there is no change in value in the system. You have lost value, but it is still there, only in someone else's pockets. To make a case against theft on the grounds of economic efficiency, we need to go deeper.
a) A burglar steals goods that you value at $1000, but he can only sell them for $500. Explain why his actions now result in economic inefficiency.
He has transferred an item from a high-valued use to a low valued use. Value is lost, which means economic inefficiency.
b) To prevent burglars from stealing, you and all your neighbors install locks that cost $100. Explain why such a response makes theft economically inefficient.
People are making expenditures that they would not have to make in a world of complete honesty. The other things that they would have done with that money (or resources used to produce locks) is a cost of crime.
c) Suppose that the thief treats crime as a business. Instead of doing honest work, he steals. Explain why making crime a business instead of a hobby makes it economically inefficient.
He could be producing something of value. His life as a thief only transfers value. The lost production is a cost.
d) If crime is economically inefficient, can a thief find that crime is a profitable occupation?
Yes. Economic efficiency is concerned about the group-wide implications of various situations.

(Comment: Do you not like the rent-seeking approach to crime? Here is a different approach. Some economists argue that social capital, though nebulous and hard to measure, is essential for economic prosperity. Social capital is the set of shared values and norms that allow a group to cooperate. Trust is an important part of social capital, and societies in which people trust only family members have been slow to develop economically. What will high crime rates or the perception of high crime rates do to trust? If trust is reduced, what effects will that have on economic activity? Can you see how the argument would be constructed?)

7 Javascript question.


 Extra Stuff . . Chapter 13 . . Chapter 14

Chapter 14 Problems in Resource Markets

1. Javascript question.

2. In the past century both population and wages have risen. How can this be explained in terms of a graph showing wages depending on marginal product?
The rise in population shifts the supply curve to the right, which should lower wages. However, the rise in population also creates a demand for output, which shifts the demand curve to the right, which should raise wages. During the past century, we have had great technological change, making people much more productive. This has shifted the demand curve for labor (which depends on productivity) to the right, which has raised wages. This last factor seems to have been the most important.

3. In the 1970s and 1980s there was considerable discussion of something called comparable worth. If you search the Internet, you can find a variety of information and viewpoints on this topic. What was the basic idea of comparable worth? Very few economists had good things to say about comparable worth. Why would economists be hostile to this idea?
Economists think the market is more likely to measure value of a worker accurately and a bureaucrat.

4. Economics can be perverse. It often suggests that government efforts to help people are ineffective.

Suppose that the government passes a law that forces businesses in a particular industry to make their workplace safer. Further, suppose that the effect of the law is to actually make the workplace safer. Will the workers be better off? Perhaps not.

If people recognized that this particular type of work was risky, would they have taken that risk into account? Suppose there are two jobs that are almost identical. The only difference is that one is more dangerous, with a greater chance that a person will be injured on the job. Will these two jobs pay the same amount?

The idea of Compensating Differentials says that when people realize that a job is risky or unpleasant, they will take that risk or unpleasantness into consideration so that in equilibrium the riskier or more unpleasant job must pay a premium. Roofers work under extremely unpleasant conditions. What should we expect about their pay? Many forms of construction work have seasonal interruptions or are at the mercy of weather. What should this do to the pay? Many people think working in a national park is fun. What should this do to the pay of national park rangers? Most people prefer day shifts to night shifts. What should we expect about pay for night work?
Roofers should earn a lot relative to jobs that are similar in skill level; construction work with weather interruptions should earn more relative to jobs that are similar level; it should not cost much to hire park rangers (though the pay effects may be obscured because pay is set by the government, not the market); night shifts should pay a premium.

What would you expect the long run effect of the effective safety regulation to be on the wages in the affected industry?
If a job becomes safer, the equilibrium wage should fall.

Suppose that a sociologist finds that unpleasant jobs have low pay. Has he shown that compensating differentials are a figment of the economist's imagination?
Compensating differentials are only one factor in determining pay, and often not the most important. If he has found a way to control for the other factors and then finds that unpleasant jobs have low pay, then he may have found something interesting. But if most unpleasant jobs require very low skill and most pleasant jobs require high skill, we should not be surprised that the unpleasant jobs pay less than the pleasant jobs.

5. Economists sometimes say that some income is in the form of "psychic income." Having a good boss or a stress-free job gives one "psychic income." Search for the term on the internet. How is psychic income related to compensating wage differentials?

Internet exploration. You should find they are different ways of talking about the same phenomenon.

6. Television has created a national market for much entertainment. As a result of that national market, there are a few entertainers who earn tremendous sums of money. Most entertainers, however, do not earn more than people in other lines of work.

The Internet has the potential to radically alter education in much the same way that television and radio has radically altered entertainment. Suppose that students begin to get their lectures via the Internet. How many different economics courses will prosper? If 50 people are offering courses, will all be equally attended? Suppose that two or three are considered a little better than the rest. Maybe they tell better jokes, have a bit more charisma, or are associated with prestigious universities. Will they get only a little more of the audience or will they get most of the audience? If you believe that the Internet is going to revolutionize education, are you more likely or less likely to pursue a career in education?
Just a guess, but I suspect that the Internet has the potential to help top teachers a lot at the expense of the great mass of teachers. Only time will tell.

7. Examine that part of the economic world you know best. To what extent do you think differences in earnings can be explained by absolute differences in productivity? Can you see cases where relative differences in performance may apply? Are there other causes you can identify contributing to pay differences? If you find them, are they consistent with firms maximizing profits?

Answers will vary.

Exploring Fairness

8. Many years ago, I attended a college founded by Benedictine monks. My economics professor, the late Martin Schirber, OSB, recounted that in days past, the school tried to apply what the monks thought were Christian principles in determining compensation. People who needed more money should be paid more than people who needed less money. So when a worker had an extra child, that family would need more money, and the worker would get a raise. Today, very few people would consider attempts to pay people based on need as fair. If you think it is unfair, why do you think it is unfair?

If you think that the pay based on need is unfair, is it fair for the government to take need into account when determining taxes? The tax code gives deductions for extra children, and it also allows the deduction of large medical bills, which can be justified with a need argument. If you think it is not right for a private employer to take need into account in determining pay, why is it right for the government to take need into account when determining taxes?

This is a discussion question with many answers possible. It does seem that consensus on what is fair has changed during the past 100 years.

9. Much discussion of issues of fairness and the ideal distribution of income is done in the language of social contract theory. This discussion recognizes a tradeoff between more equality and the total size of output; that is, it assumes that if everyone is guaranteed an equal share of total production, there is little incentive to work hard.
Suppose that you and four others are shipwrecked. As you approach a tiny island, you decide to form a social contract and these are your best guesses of what you are choosing from:

Option A: Share everything equally. Total output will be $10,000 and each will get $2000.

Option B: One-half of what each produces, each keeps; but the other half goes into a communal pot and is split up evenly. Total output will be $14,000. Before the split income will be $6000, $4000, $2000, $1000, and $1000. After the split, the incomes will be $4400, $3400, $2400, $1900, and $1900.

Option C. Each gets to keep two-thirds of what each produces, and one third is shared equally. Total output will be $15,000, so $5000 will be divided up. Original income will be $6000, $4500, $2000, $1500, and $1000. Final income will be $5000, $4000, $2333, $2000, and $1667.

Option D. Each get to keep all he or she produces. Total output will be $18,000. Incomes will be $7000, $5000, $2500, $2500, and $1000.

(In options B, C and D, you have absolutely no idea which of the five you will be. You have an equal chance of being any one of them.)

a) Which of the four options would you prefer? Why?
b) How would the numbers have to change for you prefer more or less redistribution?
c) Can you generalize your way of deciding what is best?
d) Could you rewrite this example using an allocation of dorm fines or damages? (Should everyone bear the costs, or should an effort be made to apply them to the parties that cause them? What would dorm residents decide if they make that choice at the beginning of the semester?)

This question is a discussion question that has many possible answers.

10. Ernest Hemingway and F. Scott Fitzgerald supposedly had the following exchange:

Fitzgerald: "The rich are different from us."
Hemingway: "Yes, they have more money."

Fitzgerald was fascinated by the rich, but social scientists are more interested in the poor, and the question of how the poor differ from the rest of society is a subject of debate.

a. From what you know about the world, are the poor and non-poor similar except that the poor have less money? Or are there differences between the poor and others that cause the differences in income?

Answers will vary.

b. If you think that the negative income tax is a good way to attack poverty (and many economists do), where do you probably stand on this question? Explain.

With Hemingway.

c. If you believe that people are rational, where do you probably stand?

With Hemingway.

d. How about people who think that in-kind aid is preferable to cash aid?

With Fitzgerald--the poor are not like us--they have the wrong values or are irrational.

11. In competitive markets, survival is precarious. A firm that does not earn a profit, will eventually fail. This need for profit limits what a firm is able to do and has some interesting things to say about discrimination.

Suppose that there are two groups of people, Jorities and Norities.

a) Suppose that for reasons of culture or politics, Norities are poorly educated. Norities are paid less than Jorities. Is a pay differential sustainable with competitive markets? If you say it is not, how can someone profit from a differential?
Differential sustainable because there is not profit opportunity that arises.

b) Suppose that Jorities and Norities are equally productive. However, some business owners do not like Norities and will hire them only at reduced wages. Is a pay differential sustainable with competitive markets? If you say it is not, how can someone profit from a differential?
Not sustainable. If I want to make a profit, I can enter the industry and get a bargain by hiring Norities. As long as a profit opportunity exists, people will imitate me. Only when wages are equalized will the profit opportunity cease.

c) Suppose that Jorities and Norities are equally productive. However, some customers do not like Norities and will not buy from firms that hire them. Is a pay differential sustainable with competitive markets? If you say it is not, how can someone profit from a differential?
Sustainable. However, if there are plenty of jobs behind the scenes where people do not know who is working, this pay differential may not be of importance. Customer biases should affect salesmen more than factory workers.

d) Suppose that Jorities and Norities are equally productive. However, some Jorities refuse to work with Norities. Is a pay differential sustainable with competitive markets? If you say it is not, how can someone profit from a differential?
Pay differential is not sustainable, but the workplace will be segregated. Some workplaces will be entirely Jorities and others entirely Norities. (To some extent we see this pattern in various occupations within workplaces.)

e) Suppose that a majority group does not like a minority group. Should they count on the market as a way of keeping the minority in its place, or should they look to government as a better way to achieve their goals? Explain why you answer as you do.
Historically, majorities have relied on law to enforce their dislikes and likes. Apartheid in South Africa was based on law. In the South after the Civil War, segregation was mandated by the Jim Crow laws.

Exploring the Commons

11. Explain why people can consider the following items to be free. Then explain why (or when) they are in fact scarce. Explain the problem that occurs, and give a possible solution to eliminate it.
These are all cases of the problem of the commons.
a) Ducks migrating south for the winter.
To prevent ducks from being hunted to extinction, the government sets limits on the number that can be shot.
b) Travel on a freeway during rush hour.
The problem is gridlock. A possible solution is tolls.
c) Whales in the middle of the ocean.
The problem is possible extinction. The solution has been international agreements limiting hunting.
d) Water in a river running through an industrial area.
The problem is that the river will become a sewer. Government prohibition of dumping raw waste is the normal solution.
e) Water in an aquifer in a fertile but dry area.
The problem is that people pump the aquifer dry, which is in the process of happening in several states. A possible solution would be to limit the amount people can pump.
f) Buffalo in the 19th century.
We almost killed them all. All buffalo are now owned by someone, either private individuals or governments.
g) Trees on public land on a heavily populated island that needs firewood.
The problem is that all trees are cut and the land then erodes. Easter Island in the Pacific is an example of social collapse caused by this problem. There is no easy solution.
h) Food in a college cafeteria for which students pay a fixed board fee.
Students have little incentive to avoid wasting food. A solution is to charge per item.
i) Mammoths to Ice-Age hunters.
They are extinct. Hunting may have been part of the reason they are gone.

12. Mrs. Jones brings home a dozen candy bars each Monday and tells her two children they can eat them whenever they want. Mrs. Smith also brings home a dozen candy bars each Monday and tells her two kids they can eat them, but she says that six are for the older child and six are for the younger child.
a) What does economic theory predict about the life expectancy of candy bars in these two households?
Candy bars will disappear in the Jones' household.
b) The logic in this problem illustrates the logic in what economic problem?
Problem of the commons.
c) What does this simple example suggest about property rights?
Appropriate property rights can solve the problem of the commons.

Now Javascript and slightly changed 13. Suppose that in Wayzata Sea the number of fish harvested depends on the number of boats that fish. The following table shows how the value of the catch increases as the number of boats increases. Suppose that it costs 65 to add a boat to the fishing fleet.

Number of Boats
Value of Catch
Average Catch
Marginal Catch

a) If entry of boats is unrestricted, how many boats will tend to fish in this sea?
As long average catch exceeds the cost, it is worth adding boats. Certainly the third boat will go because it will get average a catch of over 73, and the fourth boat will be indifferent to going. I perhaps should have had the cost at 64 to make that fourth boat go for sure.
b) If one company has the exclusive right to fish in this area, what is the optimal number of boats it should use?
It will only use two. It will look at the marginal catch. The third boat will only add 50 but cost 65.
c) What is the economically efficient number of boats in this problem?

Two. This is an example of the problem of the commons.

14. We have been considering a resource bundle with three uses. Use A has a value of $25 to people, use B has a value of $22, and use C has a value of $20. A system of making a choice that delivers the resources to use A was efficient, and that markets can be efficient. However, markets may fail and allocate inefficiently. How will the resources be used in the following cases?
a) An industry that has the problem of the commons finds that when there are three producers, total revenue is $120. When there are four, total revenue increases by $20 to $140. Use C is adding the fourth producer.
Resources will go to C because in the problem of commons, people look at average benefits (35), not marginal.
b) An industry has positive externalities. If more is produced, buyers will get benefits of $21, but there will be spillover benefits of $4. This use of resources is use A.
Resources will go to B. Only $21 of the $25 in benefits for use A will be considered.
c) An industry has negative externalities. If more is produced, buyers get benefits of $26, but there are spillover costs of $4. The extra production is use B.
Resources will go to B. The spillover cost will be ignored, and so use B will outbid use A.

Exploring Externalities

15. Suppose that you are the head of a pollution-control agency and you desire to cut the pollution in Starry River by one-half. The polluters, the amount they pollute, and their marginal costs of reducing wastes are given in the following table. Your staff has proposed three options. With Option A, you require each firm to reduce wastes by one-half. With Option B, you require each firm to reduce wastes by five tons. With Option C, you put a tax on the discharge of $4.50 per ton.

What is the cost to society (how much in resources is required) to clean up the river by one-half under each option? What is the cost to business under each option? Which will economists be most likely to propose? Which will the Chamber of Commerce support?
To society: A: $100; B: $115; C: $55
To business: A: $100; B: $115; C: $215
The economist will like option C since it uses the fewest resources. The tax cost is not a cost to society because there is not value lost. Funds are simply transferred from one pocket to another.
The Chamber of Commerce will probably support option A because it is cheapest to business.

Tons of Waste Per Day
Marginal Cost of Reducing a Ton of Waste
Cost of Policy A
Cost of Policy B
Cost of Policy C:
Cleanup Cost
Tax Cost

Orion Ind.


Draco C.


Auriga Bros.


Hercules Int.


Pegasus Inc.


Scorpio Entpr.


9. The analysis of the last question was the way economists once approached the problem of pollution, and this analysis suggested that a pollution tax was a good idea. There are two problems with this solution. First, as you can see from the results, the companies consider a pollution tax the most expensive option, and hence will fight it. As a result, it is very difficult to enact pollution taxes. Second, the efforts that companies spend fighting the tax calls into question the assumption that taxes are simply a transfer that does not use resources. The notion of rent seeking suggests that people spend resources trying to obtain transfers or avoid paying them, and hence assuming transfers as "free" is dangerous.

There is, however, another policy option, one that has proven easier to enact. We can create a market in pollution rights. Again, suppose that we want to cut pollution by one-half. The total amount of pollution is 60, so we will allow 30. We grant each company a right to pollute five tons. If they want to pollute more, they can do so by buying pollution rights from another company. For example, Scorpio Enterprises finds it cheap to clean up, so if the price of pollution rights exceeds $1.00, it would make more money by selling its rights to someone else and cleaning up all of its pollution.

What will the equilibrium price of pollution rights be? Who will buy and who will sell? What will the cost of this policy look like to the companies? What will it look like to society as a whole?
The equilibrium price should be somewhere between $4 and $5. Auriga, Pegasus, and Scorpio will sell their rights once they are above $4 because will pay them to clean up. If the price of the pollution rights is $4, the cost to the firms will look like this:

Orion: $20 to buy rights
Draco: $40 to buy rights
Auriga: $0 (Sold rights for $20, but cost of cleanup was $20)
Hercules $0 (had enough rights given it; did nothing.)
Pegasus $0 (Sold rights for $20, but paid $20 to clean up)
Scropio gain of $5 (Sold rights for $20, but paid $15 to clean up)

Net cost is $55. The incentives to clean up are the same as with the pollution tax, but the burden of the cost is very different.

17. Economists believe that only humans matter. Suppose that a waste product is harmful to animals but does not harm humans. Can it be pollution? Should we consider effects on animals and plants independent of effects on humans? Some people believe that plants and animals, as coinhabitors of the planet, have the same rights as humans. Do you agree or disagree? (Comment: Here is another way to get at this issue. Quite a few years ago, a child was born with a defective heart. In an attempt to save the child, the doctors at the hospital transferred a heart of a baby baboon into the human infant. At the time, there was considerable controversy about whether this was good medical practice, but we will ignore this question. There was also a group of people who said it was morally wrong to kill the baboon to save the human. They argued that the baboon had as much right to life as the human did. Do you agree or disagree? Why?)
Discussion question with many possible answers.


Extra Stuff . . Chapter 13 . . Chapter14