principles_of_economics_gregory_mankiw

1. A higher interest rate rotates the budget constraint outward . . .

BC1

I 2

I 1

(b) Higher Interest Rate Lowers Saving

BC2

1. A higher interest rate rotates the budget constraint outward . . .

BC1

I 1 I 2

A consumer’s budget constraint combinations of different goods income and the prices of the goods budget constraint equals the

The consumer’s indifference preferences. An indifference curve bundles of goods that make the happy. Points on higher indifference preferred to points on lower

slope of an indifference curve at consumer’s marginal rate of which the consumer is willing to other.

The consumer optimizes by budget constraint that lies on the curve. At this point, the slope of (the marginal rate of substitution equals the slope of the budget price of the goods).

Summar y

good falls, the impact on the

can be broken down into an income effect. The income effect is the that arises because a lower price better off. The substitution effect is

consumption that arises because a price greater consumption of the good

relatively cheaper. The income effect is movement from a lower to a higher

whereas the substitution effect is along an indifference curve to

slope.

choice can be applied in many explain why demand curves can upward, why higher wages could decrease the quantity of labor

interest rates could either increase and why the poor prefer cash to

Key Concepts

budget constraint, p. 465 indifference curve, p. 466

marginal rate of substitution, p. 467 perfect substitutes, p. 470

substitution effect, p. 475 good, p. 479

1.A consumer has income of $3,000. Wine costs $3 a glass, and cheese costs $6 a pound. Draw the consumer’s

budget constraint. What is the slope of this budget constraint?

2.Draw a consumer’s indifference curves for wine and cheese. Describe and explain four properties of these indifference curves.

3.Pick a point on an indifference curve for wine and cheese and show the marginal rate of substitution. What does the marginal rate of substitution tell us?

4.Show a consumer’s budget constraint and indifference curves for wine and cheese. Show the optimal consumption choice. If the price of wine is $3 a glass and the price of cheese is $6 a pound, what is the marginal rate of substitution at this optimum?

5.A person who consumes wine and his income increases from $3,000 happens if both wine and cheese Now show what happens if cheese

6.The price of cheese rises from $6 to $10 a pound, while the price of wine remains $3 a glass. For a consumer with a constant income of $3,000, show what happens to consumption of wine and cheese. Decompose the change into income and substitution effects.

7.Can an increase in the price of cheese possibly induce a consumer to buy more cheese? Explain.

8.Suppose a person who buys only wine and cheese is given $1,000 in food stamps to supplement his $1,000 income. The food stamps cannot be used to buy wine.

Might the consumer be better off with $2,000 in income? Explain in words and with a diagram.

1.Jennifer divides her income between coffee and croissants (both of which are normal goods). An early frost in Brazil causes a large increase in the price of coffee in the United States.

a.Show the effect of the frost on Jennifer’s budget constraint.

b.Show the effect of the frost on Jennifer’s optimal consumption bundle assuming that the substitution effect outweighs the income effect for croissants.

c.Show the effect of the frost on Jennifer’s optimal consumption bundle assuming that the income effect outweighs the substitution effect for croissants.

2.Compare the following two pairs of goods:Coke and Pepsi

Skis and ski bindings

In which case do you expect the indifference curves to be fairly straight, and in which case do you expect the indifference curves to be very bowed? In which case will the consumer respond more to a change in the relative price of the two goods?

3.Mario consumes only cheese and crackers.

a.Could cheese and crackers both be inferior goods for Mario? Explain.

b.Suppose that cheese is a normal good for Mario whereas crackers are an inferior good. If the price of cheese falls, what happens to Mario’s consumption of crackers? What happens to his consumption of cheese? Explain.

4.Jim buys only milk and cookies.

a.In 2001, Jim earns $100, milk costs $2 per quart, and cookies cost $4 per dozen. Draw Jim’s budget constraint.

b.Now suppose that all prices increase by 10 percent in 2002 and that Jim’s salary increases by 10 percent as well. Draw Jim’s new budget constraint. How would Jim’s optimal combination of milk and cookies in 2002 compare to his optimal combination in 2001?

5.Consider your decision about how many hours to work.

a.Draw your budget constraint assuming that you pay no taxes on your income. On the same diagram, draw another budget constraint assuming that you pay a 15 percent tax.

b.Show how the tax might lead to more hours of work, fewer hours, or the same number of hours. Explain.

6.Sarah is awake for 100 hours per week. Using one diagram, show Sarah’s budget constraints if she earns $6 per hour, $8 per hour, and $10 per hour. Now draw indifference curves such that Sarah’s labor supply curve is upward sloping when the wage is between $6 and $8 per hour, and backward sloping when the wage is between $8 and $10 per hour.

7.Draw the indifference curve for someone deciding how much to work. Suppose the wage increases. Is it possible that the person’s consumption would fall? Is this

plausible? Discuss. (Hint: Think about income and substitution effects.)

8.Suppose you take a job that pays $30,000 and set some of this income aside in a savings account that pays an annual interest rate of 5 percent. Use a diagram with a budget constraint and indifference curves to show how your consumption changes in each of the following situations. To keep things simple, assume that you pay no taxes on your income.

a.Your salary increases to $40,000.

b.The interest rate on your bank account rises to 8 percent.

9.As discussed in the text, we can divide an individual’s life into two hypothetical periods: “young” and “old.” Suppose that the individual earns income only when young and saves some of that income to consume when old. If the interest rate on savings falls, can you tell what happens to consumption when young? Can you tell what happens to consumption when old? Explain.

10.Suppose that your state gives each town $5 million in aid per year. The way in which the money is spent is currently unrestricted, but the governor has proposed that towns be required to spend the entire $5 million on education. You can illustrate the effect of this proposal on your town’s spending on education using a budget constraint and indifference-curve diagram. The two goods are education and noneducation spending.

a.Draw your town’s budget constraint under the existing policy, assuming that your town’s only source of revenue besides the state aid is a property tax that yields $10 million. On the same diagram, draw the budget constraint under the governor’s proposal.

b.Would your town spend more on education under the governor’s proposal than under the existing policy? Explain.

c.Now compare two towns—Youngsville and Oldsville—with the same revenue and the same state aid. Youngsville has a large school-age population, and Oldsville has a large elderly population. In which town is the governor’s proposal most likely to increase education spending? Explain.

11.(This problem is challenging.) The welfare system provides income to some needy families. Typically, the maximum payment goes to families that earn no income; then, as families begin to earn income, the welfare payment declines gradually and eventually

disappears. Let’s consider the possible effects of this program on a family’s labor supply.

a.Draw a budget constraint for a family assuming that the welfare system did not exist. On the same diagram, draw a budget constraint that reflects the existence of the welfare system.

b.Adding indifference curves to your diagram, show how the welfare system could reduce the number of hours worked by the family. Explain, with reference to both the income and substitution effects.

c.Using your diagram from part (b), show the effect of the welfare system on the well-being of the family.

12.(This problem is challenging.) Suppose that an individual owed no taxes on the first $10,000 she earned and 15 percent of any income she earned over $10,000. (This is a simplified version of the actual U.S. income tax.) Now suppose that Congress is considering two ways to reduce the tax burden: a reduction in the tax rate and an increase in the amount on which no tax is owed.

a.What effect would a reduction in the tax rate have on the individual’s labor supply if she earned $30,000 to start? Explain in words using the income and substitution effects. You do not need to use a diagram.

b.What effect would an increase in the amount on which no tax is owed have on the individual’s labor supply? Again, explain in words using the income and substitution effects.

13.(This problem is challenging.) Consider a person deciding how much to consume and how much to save for retirement. This person has particular preferences: Her lifetime utility depends on the lowest level of consumption during the two periods of her life. That is,

Utility Minimum {consumption when young, consumption when old}.

a.Draw this person’s indifference curves. (Hint: Recall that indifference curves show the combinations of consumption in the two periods that yield the same level of utility.)

b.Draw the budget constraint and the optimum.

c.When the interest rate increases, does this person save more or less? Explain your answer using income and substitution effects.

M E A S U R I N G A N A T I O N ’ S

I N C O M E

When you finish school and start looking for a full-time job, your experience will, to a large extent, be shaped by prevailing economic conditions. In some years, firms throughout the economy are expanding their production of goods and services, employment is rising, and jobs are easy to find. In other years, firms are cutting back on production, employment is declining, and finding a good job takes a long time. Not surprisingly, any college graduate would rather enter the labor force in a year of economic expansion than in a year of economic contraction.

Because the condition of the overall economy profoundly affects all of us, changes in economic conditions are widely reported by the media. Indeed, it is hard to pick up a newspaper without seeing some newly reported statistic about the economy. The statistic might measure the total income of everyone in the economy (GDP), the rate at which average prices are rising (inflation), the percentage of the labor force that is out of work (unemployment), total spending at stores (retail

IN THIS CHAPTER YOU WILL . . .

Consider why an economy’s total income equals its total expenditur e

Learn how gr oss domestic pr oduct (GDP) is defined and calculated

See the br eakdown of GDP into its four major components

Learn the distinction between r eal GDP and nominal GDP

Consider whether GDP is a good measur e of economic well - being

microeconomics

the study of how households and firms make decisions and how they interact in markets

macroeconomics the study of economy-wide

phenomena, including inflation, unemployment, and economic growth

sales), or the imbalance of trade between the United States and the rest of the world (the trade deficit). All these statistics are macroeconomic. Rather than telling us about a particular household or firm, they tell us something about the entire economy.

As you may recall from Chapter 2, economics is divided into two branches: microeconomics and macroeconomics. Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets. Macroeconomics is the study of the economy as a whole. The goal of macroeconomics is to explain the economic changes that affect many households, firms, and markets at once. Macroeconomists address diverse questions: Why is average income high in some countries while it is low in others? Why do prices rise rapidly in some periods of time while they are more stable in other periods? Why do production and employment expand in some years and contract in others? What, if anything, can the government do to promote rapid growth in incomes, low inflation, and stable employment? These questions are all macroeconomic in nature because they concern the workings of the entire economy.

Because the economy as a whole is just a collection of many households and many firms interacting in many markets, microeconomics and macroeconomics are closely linked. The basic tools of supply and demand, for instance, are as central to macroeconomic analysis as they are to microeconomic analysis. Yet studying the economy in its entirety raises some new and intriguing challenges.

In this chapter and the next one, we discuss some of the data that economists and policymakers use to monitor the performance of the overall economy. These data reflect the economic changes that macroeconomists try to explain. This chapter considers gross domestic product, or simply GDP, which measures the total income of a nation. GDP is the most closely watched economic statistic because it is thought to be the best single measure of a society’s economic well-being.

Revenue

(= GDP)

Goods

and services sold

FIRMS

Inputs for production

Wages, rent, and profit (= GDP)

gross domestic product (GDP)

the market value of all final goods and services produced within a country in a given period of time

goods and services produced in the economy. Some goods and services are bought by governments, and some are bought by firms that plan to use them in the future to produce their own output. Yet, regardless of whether a household, government, or firm buys a good or service, the transaction has a buyer and seller. Thus, for the economy as a whole, expenditure and income are always the same.

QUICK QUIZ: What two things does gross domestic product measure? How can it measure two things at once?

THE MEASUREMENT OF GROSS

DOMESTIC PRODUCT

Now that we have discussed the meaning of gross domestic product in general terms, let’s be more precise about how this statistic is measured. Here is a definition of GDP:

Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given period of time.

This definition might seem simple enough. But, in fact, many subtle issues arise when computing an economy’s GDP. Let’s therefore consider each phrase in this definition with some care.

“GDP IS THE MARKET VALUE . . .”

You have probably heard the adage, “You can’t compare apples and oranges.” Yet GDP does exactly that. GDP adds together many different kinds of products into a single measure of the value of economic activity. To do this, it uses market prices. Because market prices measure the amount people are willing to pay for different goods, they reflect the value of those goods. If the price of an apple is twice the price of an orange, then an apple contributes twice as much to GDP as does an orange.

“OF ALL . . .”

GDP tries to be comprehensive. It includes all items produced in the economy and sold legally in markets. GDP measures the market value of not just apples and oranges, but also pears and grapefruit, books and movies, haircuts and health care, and on and on.

GDP also includes the market value of the housing services provided by the economy’s stock of housing. For rental housing, this value is easy to calculate—the rent equals both the tenant’s expenditure and the landlord’s income. Yet many people own the place where they live and, therefore, do not pay rent. The government includes this owner-occupied housing in GDP by estimating its rental value. That is, GDP is based on the assumption that the owner, in effect, pays rent to himself, so the rent is included both in his expenditure and in his income.

There are some products, however, that GDP excludes because measuring them is so difficult. GDP excludes items produced and sold illicitly, such as illegal