Economic Exercises by Pierre Lemieux, Department of Management Sciences, University of Québec in Outaouais

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These exercises are meant to illustrate the basic economic concepts and the way economists in the mainstream analytical tradition think.

EXERCISE OF THE MONTH The cost of the coast guard and the fire department Question: In a recent op-ed (Financial Post, April 19, 2008), a lawyer criticized the federal government’s argument that it costs nothing to protect (or monitor) the seal hunters, because the coast guard’s boats and aircraft are owned and the crews are on salary. “Does it cost nothing to put out fires in Toronto because it owns the trucks and firefighters aren’t on piecework?,” the lawyer asked rhetorically. Does it cost something or not to send the firemen to put out a fire or the Coast Gard on a specific mission?		To receive the free monthly economic exercises, please add your name to our mailing list Enter your e-mail.   If you want to take your student role seriously, you may submit your answer (before the 20th of each month) to pierre.lemieux@uqo.ca. But be prepared to get a grade between A (excellent) and F (failure)! Your answer should be between 100 and, at most, 300 words.
Previous Economic Exercises April 01, 2008 Will your donation go to the project you think? Question: The Toronto Zoo, which is normally financed by the city, is on the verge of a big fundraising campaign. Paraphrasing a consultant involved in the plan, the Toronto Star explains that the campaign will be under the aegis of the arm’s-length Toronto Zoo Foundation because “donors want to be sure their money isn’t siphoned off into other parts of the city budget.” (February 29, 2008.) Explain why donors can be confidently sure of this. Hint: The news story is true, and the question legitimate. Yet, don’t forget that today is April Fools’ Day. Solution: Because it was April Fools’ Day, I turned the question around. It should have been: explain why donors can never be sure of this! Nothing can assure a donor that $1 given to the zoo will not lead to the City giving $1 less and spending this dollar on, say, sewage administration. To be sure that his donation has not reduced the city’s subsidy, a donor would need to know what the latter would have been without his donation. This, of course, is impossible to know. On the contrary, there are reasons to believe that the city will reduce its subsidy to the zoo in some proportion of the funds independently raised by the latter. Assume that the city is benevolent towards the zoo, making sure it gets the optimal amount of revenues – given the city’s other expenditures. If the zoo independently raises $1, the combined budget of the city and the zoo is now higher, which leads the city’s governors to think that the zoo’s subsidy should be increased, but not by $1 since, in general, expenditures on competing projects should also increase. This income effect, which presumably translates into less than $1 for the zoo (when one is richer, one spends more on everything), is compounded by a substitution effect: from the city’s benevolent viewpoint, the zoo’s budget has been made over-optimal by the private donation, which implies that it should be decreased through a reduced municipal subsidy. (To make sure that you understand, reformulate the argument considering the substitution effect first, and the income effect second.) Giving money to a project or organization that is already subsidized by somebody else will, in many circumstances, lead to a reduction of the other subsidies. Readings: The economist will note that this argument parallels Gary Becker’s “rotten kid theorem.” See Gary S. Becker, A Treatise on the Family (Cambridge: Harvard University Press, 1991), pp. 288 ff.; and “Altruism, Egoism, and Genetic Fitness: Economics and Sociobiology,” Journal of Economic Literature, Vol. 14, No. 3 (September 1996), reproduced in The Economic Approach to Human Behavior (Chicago: University of Chicago Press, 1976) – see especially pp. 286-289.
· March 01, 2008 Exchange, winners and losers Question: A book on French Canadian history, Le Mémorial du Québec (Vol. 1, Montréal: Société des éditions du Mémorial - Québec, 1980), illustrates an exchange between coureur des bois Pierre-Esprit Radisson (1636-1710) and an Indian chief. The caption says, “In an exchange, there is always a loser. Is the loser Radisson or this Indian chief?” Is it true that there is always a winner and a loser in an exchange? Context: On the fur trade by the coureurs des bois and Radisson in particular, see Library and Archives Canada, Radisson and Des Groseilliers: Ceasars of the Wilderness. · February 01, 2008 Economics and hoax detection Question: A message circulating on the Internet says the following (or a variation thereof): “Should you ever be forced by a robber to withdraw money from an ATM machine, you can notify the police that a robbery is in progress simply by entering your PIN in reverse. The machine will still give you the money you requested, but unknown to the robber, the police will be immediately dispatched to help you.” How can the economic reasoning immediately show this to be a hoax? · January 01, 2008 Minimum sentences and prices Question: The federal government intends to legislate mandatory minimum jail sentences for drug offences – including growing and selling very small quantities of marijuana (The Gazette, November 28, 2007). By increasing the cost of participating in the drug trade, this measure would reduce supply and lead to higher prices and lower consumption. Can you think of another reason why it is likely to increase drug prices? · December 01, 2007 Pumping money into the economy Question: Discussing the idea of moving the United Nations headquarters from New York City to Montréal, a columnist notes that “the city [NYC] wants to keep the UN; the world body and its more than 9,000 accredited diplomats and their families pump in more than $3-billion every year into the local economy” (National Post, October 27, 2007). Does this mean $3-billion of benefits for the local economy? · November 01, 2007 Adding Apples and Oranges Question: Start with Case 1: Suppose a simplified economy where only two consumption goods are produced: apples and oranges. There is no investment, no government expenditures, and no exports nor imports. We also assume there is no inflation. During Year 1, 10 oranges are produced and sold at $1.00 each, as well as 30 apples at a price of $0.50 each. During Year 2, because of supply and demand changes, prices and the mix of production have changed: 35 oranges are produced and sold on the market at a unit price of $1.00, and 10 apples at $2.00 each. Two questions: 1) What is GDP in Year 1 and in Year 2? 2) What is the rate of growth? Case 2: Now, suppose that production levels are the same but that prices are different: during Year 1, oranges sell for $2.00 and apples for $1.00; during year 2, the respective prices are $0.50 and $1.00. Two more questions: 3) Recalculate GDP for the two years. 4) Why has the rate of growth changed? In other words, please replace the question marks in the table below, and answer question 4. · October 01, 2007 Salaries in Developing Countries Question: An easy question, this month: What would be the impact of widespread outsourcing on salaries in the developing countries at the receiving end? Definition: “Outsourcing” is the process whereby a firm (in a developed country, in this case) shifts part of its production to a foreign branch (in a developing country). · September 01, 2007 Wealth and dollars Question: The spokesman for an activist group declares to La Presse Affaires (August 22, 2007): “Wealth is not only measured in dollars.” Is this true? · August 01, 2007 Security in Montréal Question: The City of Montreal wants to force the promoters of certain events (rock concerts and automobile races, for example) to pay for the cost of the extra police services they require (The Gazette, March 11, 2007). This idea has provoked a big debate (La Presse, July 9, 2007). Explain one major economic argument in favour of such a policy, and one major argument against it. · July 01, 2007 Economic fallouts Question: Regarding the military contracts granted to American aerospace manufacturers, a federal government spokesman was quoted in the press about “economic fallouts that are viable in the long run.” (La Presse, June 19, 2007). Can a public expenditure generate “economic fallouts”? · June 01, 2007 A dangerous free good Question: Reacting to the idea of free Wi-Fi (wireless Internet) to be supplied by the City of Montreal, a business association spokesman was recently quoted as saying, “But wireless Internet must be introduced with due respect for private enterprise. The telecom companies must not be penalized by something free. If the Internet becomes free, our economy will suffer.” (La Presse, March 31, 2007) How can the economy suffer from something free? Hint: Distinguish “free” in the sense of “supplied free by the public sector” and other possible ways something can be free. · May 01, 2007 Ethanol and hamburgers Question: How can higher ethanol production lead to fewer hamburgers being consumed? · April 01, 2007 Marginal product of an automobile worker Question: You are a consultant for a car manufacturing company or, perhaps, for its employees’ trade union. Your client asks you for a quick estimate (he needs it in one hour) of the increase in the number of cars produced and in the value of production that would follow the hiring of one more worker (other things being equal), or the decrease that would follow the laying off of one worker (other things equal). You rush to the Website of, say, car manufacturer PSA Peugeot Citroën, and find that the company employs about 200,000 workers, has annual sales of 54,900 million euros, pays an annual wage bill of 6,800 million euros, and produces 3.4 million cars per year. If you have only these numbers, can you answer the question? Hints: In economic terms, what you are looking for is the “marginal product” (also called marginal productivity) and the “marginal value product” (which is marginal productivity in dollar terms) of labour in car manufacturing. Assume that all Peugeot Citroën employees and all cars produced by Peugeot Citroën are homogeneous; that the firm maximizes its profits; and that all car manufacturers in the world market face basically the same costs. · March 01, 2007 Change in house prices Question: You have just bought a house. Will you be better off or worse off if, ceteris paribus, all house prices, including yours, increase? If, ceteris paribus, all house prices, including yours, decrease? Hints: To simplify, assume that your house is clear of mortgage. Also assume that all house prices, including the price of your house, change in the same proportion. Finally, assume that you have no special sentimental attachment to your house or neighbourhood, and that moving costs and other transaction costs are zero. Recall that ceteris paribus (“other things equal”) mean that nothing else changes in your income situation or in the rest of the world. · February 01, 2007 A society made of altruists Question: In a society made of total altruists, how could anyone help others? Hint: An altruist is defined as somebody who obtains utility (gets to a more preferred position in his preferences) when other people increase their utility; the altruist thus increases his own utility by helping others. · January 01, 2007 Win-back liberty Question: The federal government has announced its intention to abolish the regulation that prohibits the former regional telephone monopolies to try and win back customers without delay after they defect to competitors. At least one of these competitors and one analyst have argued that this will lead to lower prices not for all consumers, but only for the targeted defectors to win them back. (See National Post, December 13, 2006, p. FP-1.) What’s wrong in this reasoning? Hint: Assume, like economists do, that consumers don’t feel especially altruistic towards phone companies (or any other supplier). · December 01, 2006 GDP and the broken window Question: Is it true that, if somebody breaks a house window which is then repaired, gross domestic product (GDP) increases by the cost of the repair? · November 01, 2006 Minimum income Question: Suppose that the government creates a minimum income, or negative tax, scheme: any person who does not earn the average income is given a transfer, or negative tax, to fill the gap and lift him up to the average. Now, since every income below the average will increase, the new program implies that the average income will rise. Consequently, the minimum income threshold will also increase, in an unending virtuous circle. What’s wrong with this reasoning? Or is there anything wrong? Hint: Consider the arithmetic of the case as well as the incentives involved, and go behind the veil of money. · October 01, 2006 Wealth creation Question: Suppose one man, A, used to earn $1,000,000 a year on the market and, thus, to create $1,000,000 of new wealth every year. (I take “wealth” in its informal sense of the returns on capital while, properly speaking, it is the capital that is wealth). Another man, B, earned an annual income of $100,000 on the market. Now, suppose that A forcibly reduces B in slavery and that, with his new slave, now earns $1,500,000 per year selling his increased production on the market. Could we say that slavery has created new wealth of $400,000? · September 01, 2006 GDP and welfare Question: Under which conditions can we say that an increase or a decrease in GDP (gross domestic product, or its equivalent, national income) translates respectively into an increase or a decrease in social welfare (that is, in the welfare of the whole society)? · August 01, 2006 Superhuman beings Question: Why do politicians lie, or do they? · July 01, 2006 A tax which is not a tax? Question: The Québec government has announced that it will impose a “royalty” on petroleum products, apparently (details are still sketchy) calculated as a function of “greenhouse gases” emitted in the environment during their production process. The Environment minister has called on the companies’ “social responsibility” not to pass on this royalty to the Québec consumers (La Presse, June 16, 2006, p. A6). Will the royalty be passed on to Québec consumers or not? · June 01, 2006 Pollution as a “bad” Question: Arguing against emissions trading (markets for pollution rights), a financial columnist explained that this sort of scheme “represents a market not in ‘goods’ but in ‘bads’…”. Is it true that pollution is a bad? Hint: Reflect on what a “bad” could mean from an economic viewpoint. · May 01, 2006 Burning money Question: If you burn a $100 bill that belongs to you, instead of spending or saving it for your own benefit, will this harm or benefit other individuals? · April 01, 2006 GDP as a measure of the economy Question: The press (for example, Bloomberg.com, December 2, 2005) regularly talks about gross domestic product as “the broadest measure of the economy.” Is it true that GDP is the broadest measure of the economy? · March 01, 2006 Free wireless Internet Question: “Free Wireless Internet in Town: Each and Everybody Would Benefit” (Internet sans fil gratuit en ville: tout le monde en profiterait) ran a title in a Montréal daily, last month: Is it really possible that everybody would benefit? · February 01, 2006 Negation of the law of demand? Question: A recent story on gas prices in the business pages of a Montréal daily observed that “pump prices have been increasing non-stop for three years, and so has gas consumption.” “How is this possible?” the reporter asked, wondering about the possibility of “a negation of the economic law [of demand],” and raising the question, “why doesn’t a higher gas price bring reduced consumption, as is the case with other goods and services?” Does the simultaneous increase of price and demand contradict the law of demand? · January 01, 2006 Changes in an individual’s real income Question: To which extent can we determine how an individual’s real income (in the most general sense of his “utility” or satisfaction) changes by observing only his monetary income, the bundles of goods (and services) he chooses to consume, and the prices at which he purchases each good? To make the question manageable, consider a simplified economy with only two goods. The table below shows the quantities X and Y of these goods chosen by a given individual (his bundles), and the respective prices, PX and PY, at which they are bought, for each of two periods of time, Year 1 and Year 2. The question is: In each of the four different cases shown on the table (A, B, C, and D), can you say whether the real income of our individual has increased, decreased, or remained constant, between Year 1 and Year 2? Hints: Assume that the individual consumes no other good than the two goods considered here. (One of the two goods could be leisure, the price of leisure being the wage rate that is foregone when leisure is chosen.) Don’t be confused by the fact that, in the table, decimal comas are used instead of decimal points. · December 01, 2005 Reimbursing the public debt, and inheritances Question: Some youth organizations argue that a priority of the Québec government should be to reimburse the provincial public debt. Just consider one aspect of the question: If the Québec government was to reimburse the public debt before today’s young people start to earn a living, would these young people receive larger or smaller inheritances (net of death taxes) when their parents die (compared to what would be the case if the debt was not reimbursed now)? · November 01, 2005 Elasticities and shortages Question: Assume that the world price of a litre of gasoline is $1.25 and that, at that price, 100 units per day (a unit being, say, one million barrels) are demanded and supplied on the world market. Assume further that the elasticity of demand for gasoline is 0.8 (“inelastic” demand since the coefficient of elasticity is smaller than 1), while the elasticity of supply is 1.1 (“elastic” supply since the coefficient of elasticity is larger than 1). Now suppose that some international government cartel imposes (and effectively enforces) a price ceiling of $1.00 per litre: it is forbidden to sell gasoline at a higher price. Will there be a shortage? How many million barrels per day will be in short supply? Hints: Recall that elasticity of demand is the proportional change in quantity demanded relative to change in price (if quantity demanded drops 10% when price rises 5%, elasticity of demand is 2); and that, similarly, elasticity of supply is the ratio of the proportional change in quantity supplied to the proportional change in price. To avoid any confusion, note that the changes in price and quantity are compared with the starting price and quantity (and not, as they could be, with the ending values, or with the average of starting and ending values). · October 01, 2005 GDP and cost of living Question: Trade-union dissidents (Rapport dissident de la FTQ, de la CSQ et de la CSD au Rapport du Comité de travail sur la pérennité du système de santé et de services sociaux du Québec, Québec, July 12, 2005, p. 7) address the following critique to the main report of a government committee on which they had representatives: “The Report notes that the Québec GDP per capita is lower than the same figure for Canada and Ontario, but ignores the fact that the cost of living is lower in Québec.” Is it true that, when comparing two territories, we need to correct their GDPs with cost of living measures? · September 01, 2005 Corruption and bribes Question: There is a unique consumer who wants a given widget for which he is willing to pay $50. Producing the widget would cost a producer (assume there is only one who can do it) $20 in labour, $10 in capital, and $5 in normal profit. There are many related questions this month: (1) At which price will the widget sell? (2) What will be the value created? (3) Suppose the state prohibits the production of the widget, but there is one state official (politician or bureaucrat) who has discretion to allow the production to proceed despite the prohibition. What size of a bribe can this state official expect to get? (4) How much value does this bribe create (compared to the situation where there is no bribable state official and the prohibition is effectively enforced)? (5) Suppose that there are 10 equally powerful state officials who can, each individually, allow the production to proceed despite the prohibition. How much will be the bribe (paid to one of them)? (6) Suppose again that there is only one state official who can allow the production to proceed, but that there are 10 producers who can produce the widget (at the same costs). How much will be the bribe? (7) What is the minimum expected penalty that the state must impose to prevent bribing? · August 01, 2005 Inflation Question: A Canadian Press news item that appeared in a Montréal daily on July 23 said, “Energy is once again the main cause of inflation – especially gasoline, which increased by 4.2% in June...” What’s economically wrong with this statement? · July 01, 2005 Price and quantity increases (warp in the space-time continuum?) Question: Suppose that, in year 1, 1000 units of a widget are produced at $50 a piece; the total value of production is thus $50,000. Now suppose that, in period 2, the price increases by 2% to $51, and quantity produced by 1% to 1010. The total value of production has thus increased by 3%, from $50,000 to $51,510. This 3% increase can also be calculated by adding the price increase (2%) to the quantity increased (1%). Now, suppose that, in period 2, the quantity increase is 50% (from 1000 widgets to 1500 – instead of the former 1% increase), while the price increase stays at 2% as previously. One would think that the increase in the value of production would be 2% + 50% (price increase plus quantity increase, as before), that is, 52%. Now, it can be easily calculated that, in fact, total production value increases by 53%, that is, from $50,000 to $76,500. What is the problem in our calculations? (Is there a warp in the space time continuum?) · June 01, 2005 Opportunism and large risk Question: Commenting about a politician’s action, a Montreal editorial writer recently stated, “she takes a big risk, which is not characteristic of opportunists.” Is it true that an opportunist does not take big risks? Note: Take “opportunism” to mean “the practice or policy of adapting one’s actions, judgements, etc. to circumstances, as in politics, in order to further one’s immediate interests, without regard for basic principles…” (Webster’s New World Dictionary and Thesaurus, 1996) · May 01, 2005 An Independent Québec in a United Canada Question: Suppose that three alternatives can be put before the Québec voters: alternative A is the constitutional status quo; alternative B is a renewed federalism with more powers to the Québec government; alternative C is the separation of Québec from Canada. Is it possible that, even if each voter is individually rational, the majority would cycle between A and C – i.e., would choose both a united Canada (alternative A) and an independent Québec (alternative C)? Hint: Here, rationality means transitive preferences: if, or example, a voter prefers A to B and B to C, he will prefer A to C. · April 01, 2005 Subsidies and Market Prices Question: The Wall Street Journal of March 28, 2005, reports that the U.S. federal government is likely to give Idaho potato growers 0.035 cent (US$0.00035) per pound of potatoes they grew in 2003, because imports of Canadian French fries pushed down the price of potatoes in that year. Professor Paul Patterson, an economist at the University of Idaho, commented that the subsidy would have no effect on current potato prices. Is it possible that a subsidy on a good would have no effect on its market price? · March 01, 2005 Demand and Price Question: If demand for coffee increases, the price of coffee will increase. But if price increases, demand will drop. We are thus back to our starting point, but with a higher price. What’s wrong with this reasoning?

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