Chapter 5

Question 1

What are the alternative methods of allocating scarce resources?

Eight alternative methods that might be used are:

Answer 1

Market price

Command

Majority rule

Contest

First-come, first-served

Lottery

Personal characteristics

Force

Question 2

When a market price _________ a scarce resource, the people who are _______________________ get the resource.

Answer 2

When a market price allocates a scarce resource, the people who are willing and able to pay that price get the resource.

Question 3

wo kinds of people decide not to pay the market price

Answer 3

those who can afford to pay but choose not to buy and those who are too poor and simply can’t afford to buy.

Question 4

Command system

Answer 4

A method of allocating resources by the order (command) of someone in authority. In a firm a managerial hierarchy organizes production.

For example, if you have a job, most likely someone tells you what to do. Your labour is allocated to specific tasks by a command.

Question 5

A command system works well in organizations in which the lines of ______ and ________ are clear and it is easy to ________ the activities being performed.

Answer 5

A command system works well in organizations in which the lines of authority and responsibility are clear and it is easy to monitor the activities being performed.

Question 6

a command system works badly when the range of activities to be monitored is _____ and when it is easy for people to _____ those in authority

Answer 6

a command system works badly when the range of activities to be monitored is large and when it is easy for people to fool those in authority

Question 7

Majority Rule

Answer 7

Majority rule allocates resources in the way that a majority of voters choose.

Question 8

Societies use majority rule to _______ representative governments that make some of the biggest decisions.

Answer 8

Societies use majority rule to elect representative governments that make some of the biggest decisions.

For example, majority rule decides the tax rates that end up allocating scarce resources between private use and public use. And majority rule decides how tax dollars are allocated among competing uses such as education and healthcare.

Question 9

Majority rule works well when the decisions being made affect ___________ and ______ must be suppressed to use resources most effectively.

Answer 9

Majority rule works well when the decisions being made affect large numbers of people and self-interest must be suppressed to use resources most effectively.

Question 10

Contest

Answer 10

A contest allocates resources to a winner (or a group of winners).

Sporting events use this method. Milos Raonic competes with other tennis professionals, and the winner gets the biggest payoff. But contests are more general than those in a sports arena, though we don’t normally call them contests. For example, Bill Gates won a contest to provide the world’s personal computer operating system.

Question 11

Contests do a good job when the efforts of the “players” are _____ to monitor and _____ directly.

Answer 11

Contests do a good job when the efforts of the “players” are hard to monitor and reward directly.

When a manager offers everyone in the company the opportunity to win a big prize, people are motivated to work hard and try to become the winner. Only a few people end up with a big prize, but many people work harder in the process of trying to win. The total output produced by the workers is much greater than it would be without the contest.

Question 12

First-Come, First-Served

Answer 12

A first-come, first-served method allocates resources to those who are first in line.

Many casual restaurants won’t accept reservations. They use first-come, first-served to allocate their scarce tables. Highway space is allocated in this way too: The first to arrive at the on-ramp gets the road space. If too many vehicles enter the highway, the speed slows and people wait in line for some space to become available.

Question 13

First-come, first-served works best when a _________ can serve just ______ at a time in a sequence.

Answer 13

First-come, first-served works best when a scarce resource can serve just one user at a time in a sequence.

By serving the user who arrives first, this method minimizes the time spent waiting for the resource to become free.

Question 14

Lottery

Answer 14

Lotteries allocate resources to those who pick the winning number, draw the lucky cards, or come up lucky on some other gaming system.

Question 15

Lotteries work best when there is ____________________________________

Answer 15

Lotteries work best when there is no effective way to distinguish among potential users of a scarce resource.

Question 16

Personal Characteristics

Answer 16

When resources are allocated on the basis of personal characteristics, people with the “right” characteristics get the resources.

For example, you will choose a marriage partner on the basis of personal characteristics. But this method can also be used in unacceptable ways. Allocating the best jobs to white, Anglo-Saxon males and discriminating against visible minorities and women is an example.

Question 17

Force

Answer 17

Force plays a crucial role, for both good and ill, in allocating scarce resources

Question 18

Force - negative examples

Answer 18

War, the use of military force by one nation against another, has played an enormous role historically in allocating resources. The economic supremacy of European settlers in the Americas and Australia owes much to the use of this method.

Theft, the taking of the property of others without their consent, also plays a large role. Both large-scale organized crime and small-scale petty crime collectively allocate billions of dollars worth of resources annually.

Question 19

Force as a positive role

Force provides the state with an effective method of transferring ______ from the _____ to the ______, and it provides the legal framework in which voluntary __________ takes place.

Answer 19

Force provides the state with an effective method of transferring wealth from the rich to the poor, and it provides the legal framework in which voluntary exchange in markets takes place.

Question 20

the force of the state is essential to uphold the principle of the ________.

Answer 20

the force of the state is essential to uphold the principle of the rule of law.

This principle is the bedrock of civilized economic (and social and political) life. With the rule of law upheld, people can go about their daily economic lives with the assurance that their property will be protected—that they can sue for violations against their property (and be sued if they violate the property of others).

Question 21

The value of one more unit of a good or service is its _________

Answer 21

The value of one more unit of a good or service is its marginal benefit

We measure marginal benefit by the maximum price that is willingly paid for another unit of the good or service. But willingness to pay determines demand. A demand curve is a marginal benefit curve.

Question 22

Figure 5.1

Answer 22

In Fig. 5.1(a), Lisa is willing to pay $1 for the 30th slice of pizza and $1 is her marginal benefit from that slice. In Fig. 5.1(b), Nick is willing to pay $1 for the 10th slice of pizza and $1 is his marginal benefit from that slice. But at what quantity is the market willing to pay $1 for the marginal slice? The answer is provided by the market demand curve.

Question 23

individual demand

Answer 23

The relationship between the price of a good and the quantity demanded by one person

Question 24

market demand

Answer 24

the relationship between the price of a good and the quantity demanded by all buyers

Question 25

The market demand curve is _________________

Answer 25

The market demand curve is the horizontal sum of the individual demand curves and is formed by adding the quantities demanded by all the individuals at each price.

Question 26

Fig 5.1(c)

Answer 26

Figure 5.1(c) illustrates the market demand for pizza if Lisa and Nick are the only people in the market. Lisa’s demand curve in part (a) and Nick’s demand curve in part (b) sum horizontally to the market demand curve in part (c).

At a price of $1 a slice, Lisa demands 30 slices and Nick demands 10 slices, so the market quantity demanded at $1 a slice is 40 slices.

Question 27

Figure 5.1:

For Lisa and Nick, their demand curves are their ________________. For society, the market demand curve is the __________________.

Answer 27

For Lisa and Nick, their demand curves are their marginal benefit curves. For society, the market demand curve is the marginal benefit curve.

Question 28

We call the marginal benefit to the entire society _________________________

Answer 28

We call the marginal benefit to the entire society marginal social benefit

So the market demand curve is also the marginal social benefit (MSB) curve.

Question 29

When people buy something for less than it is worth to them, they receive a ____________.

Answer 29

When people buy something for less than it is worth to them, they receive a consumer surplus.

Question 30

Consumer surplus

Answer 30

The excess of the benefit received from a good over the amount paid for it.

It is calculated as the marginal benefit (or value) of a good minus its price, summed over the quantity bought.

Question 31

Figure 5.2(a)

Answer 31

Figure 5.2(a) shows Lisa’s consumer surplus from pizza when the price is $1 a slice. At this price, she buys 30 slices a month because the 30th slice is worth exactly $1 to her. But Lisa is willing to pay $2 for the 10th slice, so her marginal benefit from this slice is $1 more than she pays for it—she receives a surplus of $1 on the 10th slice.

Question 32

FInding consumer surplus

Lisa’s consumer surplus is the sum of the surpluses on all of the slices she buys. This sum is the area of the green triangle—the area ______ the demand curve and ______ the market price line. The area of this triangle is ______________________ which is $22.50. The area of the blue rectangle in Fig. 5.2(a) shows what Lisa pays for 30 slices of pizza.

Answer 32

Lisa’s consumer surplus is the sum of the surpluses on all of the slices she buys. This sum is the area of the green triangle—the area below the demand curve and above the market price line. The area of this triangle is equal to its base (30 slices) multiplied by its height ($1.50) divided by 2, which is $22.50. The area of the blue rectangle in Fig. 5.2(a) shows what Lisa pays for 30 slices of pizza.

Question 33

Figure 5.2(b)

Answer 33

Figure 5.2(b) shows Nick’s consumer surplus, and part (c) shows the consumer surplus for the market.

The consumer surplus for the market is the sum of the consumer surpluses of Lisa and Nick.

Question 34

All goods and services have ________ marginal benefit, so people receive _____ benefit from their consumption than the amount they pay.

Answer 34

All goods and services have decreasing marginal benefit, so people receive more benefit from their consumption than the amount they pay.

Question 35

The connection between supply and cost closely parallels the related ideas about ________________

Answer 35

The connection between supply and cost closely parallels the related ideas about demand and benefit

Question 36

Firms make a profit when they receive ______ from the _____ of a good or service than the _______________.

Answer 36

Firms make a profit when they receive more from the sale of a good or service than the cost of producing it.

Question 37

Just as consumers distinguish between _______and _______, so producers distinguish between _______ and _______.

Answer 37

Just as consumers distinguish between value and price, so producers distinguish between cost and price.

Question 38

_______ is what a firm gives up when it produces a good or service and _______ is what a firm receives when it sells the good or service.

Answer 38

Cost is what a firm gives up when it produces a good or service and price is what a firm receives when it sells the good or service.

Question 39

The cost of producing one more unit of a good or service is its ______________.

Answer 39

The cost of producing one more unit of a good or service is its marginal cost.

Marginal cost is the minimum price that producers must receive to induce them to offer one more unit of a good or service for sale.

Question 40

A supply curve is a _____________________.

Answer 40

A supply curve is a marginal cost curve.

Question 41

Figure 5.3

Answer 41

In Fig. 5.3(a), Maria is willing to produce the 100th pizza for $15, her marginal cost of that pizza. In Fig. 5.3(b), Max is willing to produce the 50th pizza for $15, his marginal cost.

What quantity is this market willing to produce for $15 a pizza? The answer is provided by the market supply curve.

Question 42

individual supply

Answer 42

The relationship between the price of a good and the quantity supplied by one producer

Question 43

market supply

Answer 43

the relationship between the price of a good and the quantity supplied by all producers

Question 44

The market supply curve

Answer 44

the horizontal sum of the individual supply curves and is formed by adding the quantities supplied by all the producers at each price.

Figure 5.3(c) illustrates the market supply of pizzas if Maria and Max are the only producers. Maria’s supply curve in part (a) and Max’s supply curve in part (b) sum horizontally to the market supply curve in part (c).

Question 45

We call the society’s marginal cost __________________

Answer 45

We call the society’s marginal cost marginal social cost

Question 46

the market supply curve is also the _____________________

Answer 46

the market supply curve is also the marginal social cost (MSC) curve

Question 47

When price exceeds marginal cost, the firm receives a ______________.

Answer 47

When price exceeds marginal cost, the firm receives a producer surplus.

Question 48

Producer surplus

Answer 48

The excess of the amount received from the sale of a good or service over the cost of producing it.

It is calculated as the price of a good minus the marginal cost (or minimum supply-price), summed over the quantity sold.

Question 49

Fig 5.4(a)

Answer 49

Figure 5.4(a) shows Maria’s producer surplus from pizza when the price is $15 a pizza. At this price, she sells 100 pizzas a month because the 100th pizza costs her $15 to produce. But Maria is willing to produce the 50th pizza for her marginal cost, which is $10, so she receives a surplus of $5 on this pizza.

Question 50

Maria’s producer surplus is the sum of the surpluses on the pizzas she sells. This sum is the area of the blue triangle—the area below the market price and above the supply curve. The area of this triangle _________________________________________.

Answer 50

Maria’s producer surplus is the sum of the surpluses on the pizzas she sells. This sum is the area of the blue triangle—the area below the market price and above the supply curve. The area of this triangle is equal to its base (100) multiplied by its height ($10) divided by 2, which is $500.

Question 51

Equilibrium in a competitive market occurs when the ____________ equals the ____________ at the ________ of the ________ and the________.

Answer 51

Equilibrium in a competitive market occurs when the quantity demanded equals the quantity supplied at the intersection of the demand curve and the supply curve.

At this intersection point, marginal social benefit on the demand curve equals marginal social cost on the supply curve. This equality is the condition for allocative efficiency. So in equilibrium, a competitive market achieves allocative efficiency.

Question 52

Figure 5.5 illustrates the efficiency of competitive equilibrium. The demand curve and the supply curve intersect in part (a) and marginal social benefit equals marginal social cost in part (b).

Answer 52

If production is less than 10,000 pizzas a day, the marginal pizza is valued more highly than it costs to produce. If production exceeds 10,000 pizzas a day, the marginal pizza costs more to produce than the value that consumers place on it. Only when 10,000 pizzas a day are produced is the marginal pizza worth exactly what it costs.

Question 53

Figure 5.5 - the competitive market

Answer 53

The competitive market pushes the quantity of pizzas produced to its efficient level of 10,000 a day. If production is less than 10,000 pizzas a day, a shortage raises the price, which increases production. If production exceeds 10,000 pizzas a day, a surplus of pizzas lowers the price, which decreases production. So a competitive pizza market is efficient.

Question 54

Total surplus

Answer 54

The sum of consumer surplus and producer surplus.

Question 55

When the efficient quantity is produced, total surplus is _________.

Answer 55

When the efficient quantity is produced, total surplus is maximized.

Question 56

Markets are not always efficient, and when a market is inefficient, we call the outcome ___________

Answer 56

Markets are not always efficient, and when a market is inefficient, we call the outcome market failure

Question 57

Market failure

Answer 57

A situation in which a market delivers an inefficient outcome

In a market failure, either too little (underproduction) or too much (overproduction) of an item is produced.

Question 58

Fig 5.6(a) - Underproduction

Answer 58

In Fig. 5.6(a), the quantity of pizzas produced is 5,000 a day. At this quantity, consumers are willing to pay $20 for a pizza that costs only $10 to produce. The quantity produced is inefficient—there is underproduction—and total surplus is smaller than its maximum possible level.

Question 59

Deadweight loss

Answer 59

A measure of inefficiency. It is equal to the decrease in total surplus that results from an inefficient level of production.

Question 60

Fig. 5.6(b) - Overproduction

Answer 60

In Fig. 5.6(b), the quantity of pizzas produced is 15,000 a day. At this quantity, consumers are willing to pay only $10 for a pizza that costs $20 to produce. By producing the 15,000th pizza, $10 of resources are wasted. Again, the grey triangle shows the deadweight loss, which reduces the total surplus to less than its maximum.

Question 61

Sources of Market Failure

Obstacles to efficiency that bring market failure are:

Answer 61

Price and quantity regulations

Taxes and subsidies

Externalities

Public goods and common resources

Monopoly

High transactions costs

Question 62

A ______________, either a price cap or a price floor, blocks the price adjustments that balance the quantity demanded and the quantity supplied and lead to underproduction.

Answer 62

A price regulation, either a price cap or a price floor, blocks the price adjustments that balance the quantity demanded and the quantity supplied and lead to underproduction.

Question 63

A ________________ that limits the amount that a farm is permitted to produce also leads to underproduction.

Answer 63

A quantity regulation that limits the amount that a farm is permitted to produce also leads to underproduction.

Question 64

Taxes ______ the prices paid by buyers, ______ the prices received by sellers, and lead to underproduction

Answer 64

Taxes increase the prices paid by buyers, lower the prices received by sellers, and lead to underproduction

Question 65

Subsidies

Answer 65

payments by the government to producers

Question 66

Subsidies ______ the prices paid by buyers, ______ the prices received by sellers, and lead to overproduction.

Answer 66

Subsidies decrease the prices paid by buyers, increase the prices received by sellers, and lead to overproduction.

Question 67

An ______ is a cost or a benefit that affects someone other than the seller or the buyer.

Answer 67

An externality is a cost or a benefit that affects someone other than the seller or the buyer.

Question 68

An ____________ arises when an electric utility burns coal and emits carbon dioxide. The utility doesn’t consider the ______ of climate change when it decides how much power to produce. The result is overproduction.

Answer 68

An external cost arises when an electric utility burns coal and emits carbon dioxide. The utility doesn’t consider the cost of climate change when it decides how much power to produce. The result is overproduction.

Question 69

An ___________ arises when an apartment owner installs a smoke detector and ______ her neighbour’s fire risk. She doesn’t consider the ______ to her neighbour when she decides how many detectors to install. The result is underproduction.

Answer 69

An external benefit arises when an apartment owner installs a smoke detector and decreases her neighbour’s fire risk. She doesn’t consider the benefit to her neighbour when she decides how many detectors to install. The result is underproduction.

Question 70

A __________ is a good or service from which everyone benefits and no one can be excluded.

Answer 70

A public good is a good or service from which everyone benefits and no one can be excluded.

National defence is an example. A competitive market would underproduce national defence because everyone would try to free ride on everyone else.

Question 71

A ____________ is owned by no one but is available to be used by everyone.

Answer 71

A common resource is owned by no one but is available to be used by everyone.

Atlantic salmon is an example. It is in everyone’s self-interest to ignore the costs they impose on others when they decide how much of a common resource to use: It is overused.

Question 72

A ____________is a firm that is the sole provider of a good or service.

Answer 72

A monopoly is a firm that is the sole provider of a good or service.

Local water supply and cable television are supplied by firms that are monopolies.

Question 73

The monopoly’s self-interest is to _______ its profit, and because it has ______________, it produces too little and charges too _______ a price: It _______.

Answer 73

The monopoly’s self-interest is to maximize its profit, and because it has no competitors, it produces too little and charges too high a price: It underproduces.

Question 74

Transactions costs

Answer 74

The opportunity costs of making trades in a market.

The costs that arise from finding someone with whom to do business, of reaching an agreement about the price and other aspects of the exchange, and of ensuring that the terms of the agreement are fulfilled.

Question 75

When transactions costs are high, the market might ____________.

Answer 75

When transactions costs are high, the market might underproduce.

Question 76

A group that pursues the __________ of its members can become the majority.

Answer 76

A group that pursues the self-interest of its members can become the majority.

For example, a price or quantity regulation that creates inefficiency is almost always the result of a self-interested group becoming the majority and imposing costs on the minority. Also, with majority rule, votes must be translated into actions by bureaucrats who have their own agendas based on their self-interest.

Question 77

Economists agree about _________.

Answer 77

Economists agree about efficiency.

That is, they agree that it makes sense to make the economic pie as large as possible and to produce it at the lowest possible cost.

Question 78

Economists do not agree about _________

Answer 78

Economists do not agree about equity

That is, they do not agree about what are fair shares of the economic pie for all the people who make it.

Question 79

To think about fairness, think of economic life as a game—a serious game. All ideas about fairness can be divided into two broad groups. They are:

Answer 79

It’s not fair if the result isn’t fair.

It’s not fair if the rules aren’t fair.

Question 80

The nineteenth-century idea that only equality brings efficiency is called _________.

Answer 80

The nineteenth-century idea that only equality brings efficiency is called utilitarianism.

Question 81

Utilitarianism

Answer 81

A principle that states that we should strive to achieve “the greatest happiness for the greatest number of people.”

The people who developed this idea were known as utilitarians. They included eminent thinkers such as Jeremy Bentham and John Stuart Mill.

Question 82

Utilitarian Belief

Answer 82

Utilitarians argued that to achieve “the greatest happiness for the greatest number,” income must be transferred from the rich to the poor up to the point of complete equality—to the point at which there are no rich and no poor.

Question 83

Utilitarian Reasoning

Answer 83

They reasoned in the following way: First, everyone has the same basic wants and a similar capacity to enjoy life. Second, the greater a person’s income, the smaller is the marginal benefit of a dollar. The millionth dollar spent by a rich person brings a smaller marginal benefit to that person than the marginal benefit that the thousandth dollar spent brings to a poorer person. So by transferring a dollar from the millionaire to the poorer person, more is gained than is lost. The two people added together are better off.

Question 84

Fig 5,7

Answer 84

Figure 5.7 illustrates this utilitarian idea. Tom and Jerry have the same marginal benefit curve, MB. (Marginal benefit is measured on the same scale of 1 to 3 for both Tom and Jerry.) Tom is at point A. He earns $5,000 a year, and his marginal benefit from a dollar is 3 units. Jerry is at point B. He earns $45,000 a year, and his marginal benefit from a dollar is 1 unit. If a dollar is transferred from Jerry to Tom, Jerry loses 1 unit of marginal benefit and Tom gains 3 units. So together, Tom and Jerry are better off—they are sharing the economic pie more efficiently. If a second dollar is transferred, the same thing happens: Tom gains more than Jerry loses. And the same is true for every dollar transferred until they both reach point C. At point C, Tom and Jerry have $25,000 each and a marginal benefit of 2 units. Now they are sharing the economic pie in the most efficient way. It brings the greatest happiness to Tom and Jerry.

Question 85

One big problem with the utilitarian ideal of complete equality is that it ignores the costs of making __________________

Answer 85

One big problem with the utilitarian ideal of complete equality is that it ignores the costs of making income transfers.

Question 86

Big tradeoff

Answer 86

The tradeoff between efficiency and fairness.

The big tradeoff is based on the following facts. Income can be transferred from people with high incomes to people with low incomes only by taxing the high incomes.

Question 87

Taxing people’s income from employment makes them ______________.

Answer 87

Taxing people’s income from employment makes them work less.

It results in the quantity of labour being less than the efficient quantity. Taxing people’s income from capital makes them save less. It results in the quantity of capital being less than the efficient quantity.
With smaller quantities of both labour and capital, the quantity of goods and services produced is less than the efficient quantity. The economic pie shrinks.

Question 88

The greater the amount of income redistribution through income taxes, the greater is the _________

Answer 88

The greater the amount of income redistribution through income taxes, the greater is the inefficiency—the smaller is the economic pie.

Question 89

There is a second source of inefficiency. A dollar taken from a rich person does not end up as a dollar in the hands of a __________________.

Answer 89

There is a second source of inefficiency. A dollar taken from a rich person does not end up as a dollar in the hands of a poorer person.

Some of the dollar is spent on administration of the tax and transfer system. The cost of the tax-collecting agency, Canada Revenue Agency (CRA), and the welfare-administering agencies, such as Employment and Social Development Canada, must be paid with some of the taxes collected. Also, taxpayers hire accountants, auditors, and lawyers to help them ensure that they pay the correct amount of taxes. These activities use skilled labour and capital resources that could otherwise be used to produce goods and services that people value.

When all these costs are taken into account, taking a dollar from a rich person does not give a dollar to a poor person. It is possible that with high taxes, people with low incomes might end up being worse off. Suppose, for example, that highly taxed entrepreneurs decide to work less hard and shut down some of their businesses. Low-income workers get fired and must seek other, perhaps even lower-paid, work.

Question 90

A Theory of Justice, published in 1971.

Answer 90

Rawls says that, taking all the costs of income transfers into account, the fair distribution of the economic pie is the one that makes the poorest person as well off as possible. The incomes of rich people should be taxed, and after paying the costs of administering the tax and transfer system, what is left should be transferred to the poor. But the taxes must not be so high that they make the economic pie shrink to the point at which the poorest person ends up with a smaller piece. A bigger share of a smaller pie can be less than a smaller share of a bigger pie. The goal is to make the piece enjoyed by the poorest person as big as possible.

Question 91

Symmetry principle

Answer 91

A requirement that people in similar situations be treated similarly

It is the moral principle that lies at the centre of all the big religions and that says, in some form or other, “Behave toward other people in the way you expect them to behave toward you.”

Question 92

Nozick argues that the idea of fairness as an outcome or result cannot work and that fairness must be based on the fairness of the rules. He suggests that fairness obeys two rules:

Answer 92

The state must enforce laws that establish and protect private property.

Private property may be transferred from one person to another only by voluntary exchange.

Question 93

Symmetry Rule - examples

Answer 93

First, suppose that some resources or goods are not owned. They are common property. Then everyone is free to participate in a grab to use them. The strongest will prevail. But when the strongest prevails, the strongest effectively owns the resources or goods in question and prevents others from enjoying them.

Second, suppose that we do not insist on voluntary exchange for transferring ownership of resources from one person to another. The alternative is involuntary transfer. In simple language, the alternative is theft.

Both of these situations violate the symmetry principle. Only the strong acquire what they want. The weak end up with only the resources and goods that the strong don’t want.

Question 94

Price gouging

Answer 94

Price gouging is the practice of offering an essential item for sale following a natural disaster at a price much higher than its normal price.