Problem Set 4 Answers PDF

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Econ 162-A1, A2 Fall 2015

Kenny Christianson due: October 16

ANSWER KEY – PROBLEM SET NUMBER FOUR 1. Here are the 3 choices and preferences of the House of Representatives: Choice A: the British model of public doctors. Choice B: the Canadian model of universal health insurance. Choice C: the American model of market-based health care. The positions of each group are as shown below: liberals first choice second choice third choice

A B C

moderates B C A

conservatives C A B

Each group consists of 145 members. Voting by majority rule will provide different results depending on which alternatives are presented first. For example: A v B – A wins with 290 votes. (Liberals and conservatives prefer A over B) B v C – B wins with 290 votes. (Liberals and moderates prefer B over C.) Since A is preferred to B and B is preferred to C, transitivity implies that A should be preferred to C. But: A v C – C wins with 290 votes. (Moderates and conservatives prefer C over A.) So majority rule provides an inconsistent outcome. Any of the three alternatives may be preferred depending on the order of the vote. Those who control the agenda may be able to control the outcome of the vote. 2. There are many inherent problems with illegalized markets, on both the demand and the supply sides of the market. On the supply side, criminals will have a comparative advantage in supplying illegal goods. Suppliers have an incentive to offer more potent versions of the product to maximize value per weight and minimize their risk of detection. Increased enforcement decreases the supply curve, which leads to increased profits for suppliers. In illegal markets suppliers need not make any guarantees about the quality of the product. Since legal contracts cannot be enforced, violence becomes the primary means of contract enforcement. On the demand side, consumers often lack information about the quality of the product and reliability of suppliers. Consumers also have an incentive to increase the intensity of consumption, to minimize the time spent in consumption in order to reduce the opportunity costs of detection, arrest and conviction. Demand decreases when a good is made illegal, as some consumers’ tastes change away from the now illegal good.

Econ 162-A1, A2

Fall 2015

Answer key 4

2

In summary, when the government tries to protect us by prohibiting production and consumption in a market, it often only serves to make the market more dangerous but exchange in the market still takes place. The effects of legalizing prostitution would be to increase the demand for and the supply of prostitution. Supply increases because a cost of production (the risk of getting caught) has been eliminated. Demand also increases, assuming that consumers’ tastes for prostitution would change with legalization. The quantity exchanged in the market will increase, while the effect on price is indeterminate. It depends on the relative changes in demand and supply. Graphically, P S S’ P* P’ Q*

D D’ Q’

Q

If supply increases more than demand increases, then price will go down. The more elastic is the demand for prostitution, then the greater will be the increase in consumption that results from any increase in supply. 3. a If cigarettes are made illegal then GDP would decrease. Even if there was no change in economic activity, cigarette sales would now be excluded in GDP statistics. GDP does not include the value of transactions in illegal markets. b. If a man is married to a tax accountant, then his wife can do his taxes at home. Since it is not a market transaction it would not be included in GDP. If they get a divorce the man would now have to hire a tax accountant in a market, so GDP would increase. Also with a divorce another household must be set up, which also increases GDP. c. If Goodyear sells more tires to consumers, that would be an increase in final sales so GDP would increase. c. If Goodyear sells more tires to Ford, that has no effect on GDP since the tires are an intermediate good. e. The price of Apple stock rising has no effect on GDP. The sale and purchase of securities is not included in GDP. f. If your grandmother knits you a sweater, that has no effect on GDP. Goods and services produced inside the home for use inside the home are not included in GDP. g. If you buy a sweater from Bloomingdales GDP would increase, since the product is exchanged in a market. GDP includes all of those final goods and services exchanged in markets. 4. GDP can be calculated in two ways, using either the final goods approach or the value-added approach. With the final goods approach, $75 million of peanut butter was sold to final consumers, so GDP would be $75 million.

Econ 162-A1, A2

Fall 2015

Answer key 4

3

With the value-added approach, GDP is the sum of value-added in each stage of production: Activity value-added Peanut farmers sold $20 million worth of peanuts to distributors. $20 million Distributors sold $30 million worth of peanuts to processors. $10 million Processors sold $50 million worth of peanut butter to producers. $20 million Producers sold $60 million worth of jars of peanut butter to grocers. $10 million Grocers sold $75 million worth of jars of peanut butter to final consumers. $15 million total value-added

$75 million

In both cases, using either the final goods approach or the value-added approach, GDP is equal to $75 million. GDP is not the sum of all of the intermediate goods, which would equal $235 million instead of $75 million. 5. a. Real GDP increased by 1.5% in 2013, and by 2.4% in 2014. For 2015II, the rate of GDP growth was 3.9%. Generally, GDP growth has been positive since the recession of 2008 except for the first quarter of 2014 when GDP fell by 0.9%. GDP is measured using the categories of consumption, investment, net exports, and government spending. b. Nominal GDP was $16,663.2 billion in 2013, $17,348.1 billion in 2014, and $17,913.7 billion in 2015II. c. Real GDP was $15,583.3 billion in 2013, $15,961.7 billion in 2014, and $16,333.6 billion in 2015II, in chained 2009 dollars. d. Table 1.7.5 shows the relation of GDP, GNP, NNP, NI and PI. The table goes from GDP to personal income in the following way: Gross domestic product Plus: Income receipts from the rest of the world Less: Income payments to the rest of the world Equals: Gross national product Less: Consumption of fixed capital Private Domestic business Capital consumption allowances Less: Capital consumption adjustment Households and institutions Government General government Government enterprises Equals: Net national product Less: Statistical discrepancy Equals: National income Less: Corporate profits with inventory valuation and capital consumption allowance Taxes on production and imports less subsidies Contributions for government social insurance

Econ 162-A1, A2

Fall 2015

Answer key 4

Net interest and miscellaneous payments on assets Business current transfer payments (net) Current surplus of government enterprises Wage accruals less disbursements Plus: Personal income receipts on assets Personal current transfer receipts Equals: Personal income e. According to Table 2.1, the major components of personal income are wages, other labor income, proprietors’ income (profits), rental income, personal dividend income, personal interest income, and transfer payments. f. The implicit price deflator was 106.929 for 2013, 108.686 for 2014, and 109.674 for 2015II. This means that prices have increased by 6.929% from 2009 to 2013, and by 8.686% from 2009 to 2014, since the year 2009 is the base year where the price deflator = 100.

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