Chapter 1
Analyzing Economic Problems
Solutions to Review Questions
1. What is the difference between microeconomics and macroeconomics?
Microeconomics studies the economic behavior of individual economic decision makers,
such as a consumer, a worker, a firm, or a manager. Macroeconomics studies how an entire
national economy performs, examining such topics as the aggregate levels of income and
employment, the levels of interest rates and prices, the rate of inflation, and the nature of
business cycles.
2. Why is economics often described as the science of constrained choice?
While our wants for goods and services are unlimited, the resources necessary to produce
those goods and services, such as labor, managerial talent, capital, and raw materials, are
“scarce” because their supply is limited. This scarcity implies that we are constrained in the
choices we can make about which goods and services to produce. Thus, economics is often
described as the science of constrained choice.
3. How does the tool of constrained optimization help decision makers make
choices? What roles do the objective function and constraints play in a model of
constrained optimization?
Constrained optimization allows the decision maker to select the best (optimal) alternative
while accounting for any possible limitations or restrictions on the choices. The objective
function represents the relationship to be maximized or minimized. For example, a firm’s
profit might be the objective function and all choices will be evaluated in the profit function
to determine which yields the highest profit. The constraints place limitations on the choice
the decision maker can select and defines the set of alternatives from which the best will be
chosen.
4. Suppose the market for wheat is competitive, with an upward-sloping supply
curve, a downward-sloping demand curve, and an equilibrium price of $4.00 per
bushel. Why would a higher price (e.g., $5.00 per bushel) not be an equilibrium price?
,Why would a lower price (e.g., $2.50 per bushel) not be an equilibrium price?
If the price in the market was above the equilibrium price, consumers would be willing to
purchase fewer units than suppliers would be willing to sell, creating an excess supply. As
suppliers realize they are not selling the units they have made available, sellers will bid
down the price to entice more consumers to purchase their goods or services. By definition,
equilibrium is a state that will remain unchanged as long as exogenous factors remain
unchanged. Since in this case suppliers will lower their price, this high price cannot be an
equilibrium.
When the price is below the equilibrium price, consumers will demand more units than
suppliers have made available. This excess demand will entice consumers to bid up the
prices to purchase the limited units available. Since the price will change, it cannot be an
equilibrium.
5. What is the difference between an exogenous variable and an endogenous
variable in an economic model? Would it ever be useful to construct a model that
contained only exogenous variables (and no endogenous variables)?
Exogenous variables are taken as given in an economic model, i.e., they are determined by
some process outside the model, while endogenous variables are determined within the
economic model being studied.
An economic model that contained no endogenous variables would not be very interesting.
With no endogenous variables, nothing would be determined by the model so it would not
serve much purpose.
6. Why do economists do comparative statics analysis? What role do endogenous
variables and exogenous variables play in comparative statics analysis?
Comparative statics analyses are performed to determine how the levels of endogenous
variables change as some exogenous variable is changed. This type of analysis is very
important since in the real world the exogenous variables, such as weather, policy tools, etc.
are always changing and it is useful to know how changes in these variables affect the levels
of other, endogenous, variables. An example of comparative statics analysis would be
asking the question: If extraordinarily low rainfall (an exogenous variable) causes a 30
percent reduction in corn supply, by how much will the market price for corn (an
endogenous variable) increase?
7. What is the difference between positive and normative analysis? Which of the
following questions would entail positive analysis, and which normative analysis?
a) What effect will Internet auction companies have on the profits of local automobile
,dealerships?
b) Should the government impose special taxes on sales of merchandise made over
the Internet?
Positive analysis attempts to explain how an economic system works or to predict how it
will change over time by asking explanatory or predictive questions. Normative analysis
focuses on what should be done by asking prescriptive questions.
a) Because this question asks whether dealership profits will go up or down
(and by how much) – but refrains from inquiring as to whether this would
be a good thing – it is an example of positive analysis.
b) On the other hand, this question asks whether it is desirable to impose taxes
on Internet sales, so it is normative analysis. Notably, this question does not
ask what the effect of such taxes would be.
Solutions to Problems
1.1 Discuss the following statement: “Since supply and demand curves are always
shifting, markets never actually reach an equilibrium. Therefore, the concept of
equilibrium is useless.”
While the claim that markets never reach an equilibrium is probably debatable, even if
markets do not ever reach equilibrium, the concept is still of central importance. The
concept of equilibrium is important because it provides a simple way to predict how market
prices and quantities will change as exogenous variables change. Thus, while we may never
reach a particular equilibrium price, say because a supply or demand schedule shifts as the
market moves toward equilibrium, we can predict with relative ease, for example, whether
prices will be rising or falling when exogenous market factors change as we move toward
equilibrium. As exogenous variables continue to change we can continue predict the
direction of change for the endogenous variables, and this is not “useless.”
1.2 In an article entitled, “Corn Prices Surge on Export Demand, Crop Data,” The
Wall Street Journal identified several exogenous shocks that pushed U.S. corn prices
sharply higher.3 Suppose the U.S. market for corn is competitive, with an upward-
sloping supply curve and a downward-sloping demand curve. For each of the
following scenarios, illustrate graphically how the exogenous event described will
contribute to a higher price of corn in the U.S. market.
, a) The U.S. Department of Agriculture announces that exports of corn to Taiwan and
Japan were “surprisingly bullish,” around 30 percent higher than had been expected.
b) Some analysts project that the size of the U.S. corn crop will hit a six-year low
because of dry weather.
c) The strengthening of El Niño, the meteorological trend that brings warmer weather
to the western coast of South America, reduces corn production outside the United
States, thereby increasing foreign countries’ dependence on the U.S. corn crop.
3See the article by Aaron Lucchetti, August 22, 1997, p. C17. on national income. Assume that an
increase in national
a) Surprisingly high export sales mean that the demand for corn was higher
than expected, at D2 rather than D1.
P
S
P2
P1
D2
D1
Q
b) Dry weather would reduce the supply of corn, to S2 rather than S1.
P S2
P2
S1
P1
D
Q
Analyzing Economic Problems
Solutions to Review Questions
1. What is the difference between microeconomics and macroeconomics?
Microeconomics studies the economic behavior of individual economic decision makers,
such as a consumer, a worker, a firm, or a manager. Macroeconomics studies how an entire
national economy performs, examining such topics as the aggregate levels of income and
employment, the levels of interest rates and prices, the rate of inflation, and the nature of
business cycles.
2. Why is economics often described as the science of constrained choice?
While our wants for goods and services are unlimited, the resources necessary to produce
those goods and services, such as labor, managerial talent, capital, and raw materials, are
“scarce” because their supply is limited. This scarcity implies that we are constrained in the
choices we can make about which goods and services to produce. Thus, economics is often
described as the science of constrained choice.
3. How does the tool of constrained optimization help decision makers make
choices? What roles do the objective function and constraints play in a model of
constrained optimization?
Constrained optimization allows the decision maker to select the best (optimal) alternative
while accounting for any possible limitations or restrictions on the choices. The objective
function represents the relationship to be maximized or minimized. For example, a firm’s
profit might be the objective function and all choices will be evaluated in the profit function
to determine which yields the highest profit. The constraints place limitations on the choice
the decision maker can select and defines the set of alternatives from which the best will be
chosen.
4. Suppose the market for wheat is competitive, with an upward-sloping supply
curve, a downward-sloping demand curve, and an equilibrium price of $4.00 per
bushel. Why would a higher price (e.g., $5.00 per bushel) not be an equilibrium price?
,Why would a lower price (e.g., $2.50 per bushel) not be an equilibrium price?
If the price in the market was above the equilibrium price, consumers would be willing to
purchase fewer units than suppliers would be willing to sell, creating an excess supply. As
suppliers realize they are not selling the units they have made available, sellers will bid
down the price to entice more consumers to purchase their goods or services. By definition,
equilibrium is a state that will remain unchanged as long as exogenous factors remain
unchanged. Since in this case suppliers will lower their price, this high price cannot be an
equilibrium.
When the price is below the equilibrium price, consumers will demand more units than
suppliers have made available. This excess demand will entice consumers to bid up the
prices to purchase the limited units available. Since the price will change, it cannot be an
equilibrium.
5. What is the difference between an exogenous variable and an endogenous
variable in an economic model? Would it ever be useful to construct a model that
contained only exogenous variables (and no endogenous variables)?
Exogenous variables are taken as given in an economic model, i.e., they are determined by
some process outside the model, while endogenous variables are determined within the
economic model being studied.
An economic model that contained no endogenous variables would not be very interesting.
With no endogenous variables, nothing would be determined by the model so it would not
serve much purpose.
6. Why do economists do comparative statics analysis? What role do endogenous
variables and exogenous variables play in comparative statics analysis?
Comparative statics analyses are performed to determine how the levels of endogenous
variables change as some exogenous variable is changed. This type of analysis is very
important since in the real world the exogenous variables, such as weather, policy tools, etc.
are always changing and it is useful to know how changes in these variables affect the levels
of other, endogenous, variables. An example of comparative statics analysis would be
asking the question: If extraordinarily low rainfall (an exogenous variable) causes a 30
percent reduction in corn supply, by how much will the market price for corn (an
endogenous variable) increase?
7. What is the difference between positive and normative analysis? Which of the
following questions would entail positive analysis, and which normative analysis?
a) What effect will Internet auction companies have on the profits of local automobile
,dealerships?
b) Should the government impose special taxes on sales of merchandise made over
the Internet?
Positive analysis attempts to explain how an economic system works or to predict how it
will change over time by asking explanatory or predictive questions. Normative analysis
focuses on what should be done by asking prescriptive questions.
a) Because this question asks whether dealership profits will go up or down
(and by how much) – but refrains from inquiring as to whether this would
be a good thing – it is an example of positive analysis.
b) On the other hand, this question asks whether it is desirable to impose taxes
on Internet sales, so it is normative analysis. Notably, this question does not
ask what the effect of such taxes would be.
Solutions to Problems
1.1 Discuss the following statement: “Since supply and demand curves are always
shifting, markets never actually reach an equilibrium. Therefore, the concept of
equilibrium is useless.”
While the claim that markets never reach an equilibrium is probably debatable, even if
markets do not ever reach equilibrium, the concept is still of central importance. The
concept of equilibrium is important because it provides a simple way to predict how market
prices and quantities will change as exogenous variables change. Thus, while we may never
reach a particular equilibrium price, say because a supply or demand schedule shifts as the
market moves toward equilibrium, we can predict with relative ease, for example, whether
prices will be rising or falling when exogenous market factors change as we move toward
equilibrium. As exogenous variables continue to change we can continue predict the
direction of change for the endogenous variables, and this is not “useless.”
1.2 In an article entitled, “Corn Prices Surge on Export Demand, Crop Data,” The
Wall Street Journal identified several exogenous shocks that pushed U.S. corn prices
sharply higher.3 Suppose the U.S. market for corn is competitive, with an upward-
sloping supply curve and a downward-sloping demand curve. For each of the
following scenarios, illustrate graphically how the exogenous event described will
contribute to a higher price of corn in the U.S. market.
, a) The U.S. Department of Agriculture announces that exports of corn to Taiwan and
Japan were “surprisingly bullish,” around 30 percent higher than had been expected.
b) Some analysts project that the size of the U.S. corn crop will hit a six-year low
because of dry weather.
c) The strengthening of El Niño, the meteorological trend that brings warmer weather
to the western coast of South America, reduces corn production outside the United
States, thereby increasing foreign countries’ dependence on the U.S. corn crop.
3See the article by Aaron Lucchetti, August 22, 1997, p. C17. on national income. Assume that an
increase in national
a) Surprisingly high export sales mean that the demand for corn was higher
than expected, at D2 rather than D1.
P
S
P2
P1
D2
D1
Q
b) Dry weather would reduce the supply of corn, to S2 rather than S1.
P S2
P2
S1
P1
D
Q
