Solution Manual for Economics, 1st Edition

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ContentsChapter 1The Principles and Practice of Economics1Chapter2Economic Methods and Economic Questions9Chapter3Optimization: Doing the Best You Can17Chapter4Demand, Supply, and Equilibrium27Chapter5TheWealth of Nations: Defining and MeasuringMacroeconomic Aggregates39Chapter6Aggregate Incomes53Chapter7Economic Growth69Chapter8Why Isn’t the Whole World Developed?87Chapter9Employment and Unemployment103Chapter 10Credit Markets119Chapter 11The Monetary System135Chapter 12Economic Fluctuations149Chapter 13Macroeconomic Policy163

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ContentsivChapter 14Macroeconomics and International Trade179Chapter 15Open Economy Macroeconomics195

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Chapter 1The Principles and Practice of EconomicsQuestions1.Whydo we have to pay a price for most of the goods we consume?Answer: The inputs we use to produce most goods and services (for example, capital and labor) arescarce. Therefore almost all goods and services are scarce compared to the quantity that consumerswant to consume. In other words,at a price of zerothe demand for most goods is higher than theavailable supply; our wants are unlimited but our resources are not. Prices act as a rationingmechanism to prevent the overconsumption of such scarce goods, making them available in thequantitysuch thatthe supply of these goods matches the demand.2.Many people believe that the study of economics is focused on money andfinancial markets. Basedon your reading of the chapter, how would you define economics?Answer:Economics is the study of how agents (for example, households andfirms) choose to allocatescarce resources and how these choices affect society.Although it istruethat economics studiesmoney and the financial markets, the study of economics is really focused on human behavior andchoices. Given that we have limited resources, we need to choose between various options. Economicanalysis is used to understand people’s choicesin order todescribe what people do and recommendwhat people ought to do.3.Examine the following statements and determine if they are normative or positive in nature. Explainyour answer.a.The U.S. automotive industry registered its highest growth rate in5years in 2012; U.S. auto salesincreased by 13% compared to 2011.b.The U.S. government should increase carbon taxes to control emissions that cause globalwarming.Answer:a.This is an objective statement about the rate of growth in the U.S. automotive industry.Positive economics is analysis that generates objective descriptions or predictions about theworld that can be verified with data. Since data can be used here to verify the rate of growthand whether it is the highest in five years, this is a positive statement.b.The statement that the government should increase carbon taxes to control emissions isnormative since it states what the government ought to do. Normative economics advisesindividuals and society on their decisions and is almost always dependent on subjectivejudgments.

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2Acemoglu, Laibson, and List|Macroeconomics4.How does microeconomics differ from macroeconomics? Would the supply of iPhones in the UnitedStates be studied under microeconomics or macroeconomics? What about the growth rate of totaleconomic output in the national economy?Answer: Microeconomics is the study of how individuals, households, firms, and governments makechoices, and how those choices affect prices, the allocation of resources, and the well-being of otheragents. Macroeconomics is the study of the economy as a whole. Macroeconomists study factors thataffect overall–in other words, aggregate–economic performance.Macroeconomics is the study ofthe forest as a whole. Microeconomics is the study of individual trees.The supply of iPhones refers to the supply of a good by an individual firm, Apple. Therefore, theiPhone market will be studied under microeconomics. Microeconomics studies how individuals,households, firms and governments make choices, and how those choices affect prices and theallocation of resources. The growth rate of total economic output, on the other hand, refers to theaggregate American economy, and isthereforestudied under macroeconomics.5.What does a budget constraint represent? How do budget constraints explain the trade-offs thatconsumers face?Answer:A budget constraint is an equation representing the goods or activities that a consumer canchoose given her limited budget. Tradeoffs arise when some benefits must be given up in order togain others. In other words, a tradeoff occurs when you give one thing up to get something else. Sincea budget constraint shows the set of things thatyoucan choose to do or buy with a fixed amount ofmoney, it also shows that ifyouchoose to buy more of one good,youwill have to buy less ofanother. Therefore, a budget constraint equation implies thataconsumer faces a tradeoff.6.This chapter introduces the idea of opportunity cost.a.What is meant by opportunity cost? How are the opportunity costs of various choices compared?b.What is the opportunity cost of taking a year after graduating from high school and backpackingacross Europe? Are people who do so being irrational?Answer:a.Opportunity cost is the best alternative use of a resource. The opportunity cost of a particularchoice is measured in terms of the benefit foregone from the next best alternative. Tofacilitate comparison, the benefits and costs of various choices are translated into monetaryunits like dollars.b.The opportunity cost of backpacking across Europe, for a particular person,is the cost ofanything else that could have been done in that year. The backpacker could have attendedcollege or started working. These costs are the opportunity costs of the gap year. This,however, does not mean that backpackers are irrational, because the benefits may exceed thecost. Every action has an opportunity cost. The choices that people make are optimal basedon their perceived costs and benefits.7.Suppose your New Year’sresolution is to get back in shape. You are considering various ways ofdoing this; you can sign up for a gym membership, walk to work, take the stairs instead of theelevator, or watch your diet. How would you evaluate these options and choose an optimal one?Answer: You can use cost-benefit analysis to compare the various feasible alternatives and pick thebest one. Cost-benefit analysis is a calculation that adds up costs and benefits using a common unit ofmeasurement, like dollar values. The costs and benefits of using the gym, walking, taking the stairs,or dieting need to be converted into dollar values. This will include monetary as well as opportunitycosts. You can then choose the option that offers you the greatest net benefit.

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Chapter 1|The Principles and Practice of Economics38.Suppose the market price of corn is $5.50 per bushel. What are the three conditions that will need tobe satisfied for the corn market to be in equilibrium at this price?Answer: For the market to be in equilibrium, three conditions will need to be satisfied.At the price of $5.50 per bushel, the amount of corn produced by sellers should be equal tothe amount of corn purchased by buyers in the market.Farmers have chosen the optimal quantity of corn to produce given theprice of $5.50 perbushel.Consumers have chosen the optimal quantity of corn to buy given the price of $5.50 perbushel.9.Economists are often concerned with the free-rider problem.a.What is meant by free riding? Explain with an example.b.Are public parks subject to the free-rider problem? What about keeping city streets clean?Explain your answer.Answer:a.A free rider is a person who receives the benefit of a good but avoids paying for it.Peopletend to pursue their own private interests and usually don’t contribute voluntarily to thepublic interest. For example, watching a pirated copy of a movie ischeaperthan buying one.Those who watch the pirated version are essentially free riders because there are others whobuy the movie or pay for movie tickets. If everyone watched pirated copies, making movieswould not be profitable and the industry would not function.b.Cleaning of city streets may be subject to free riding. Suppose the streets are cleaned everyday at a fixed cost. This cost is borne by those who pay taxes to the city government.However, they cannot prevent others who do not pay taxes from using the clean streets. Thisleads to the free rider problem.Public parks, however,can avoid the free rider problembysetting an entrance fee. This means that only those who pay toward the maintenance andupkeep of the park will be able to use it.10.Explain the concept of causation with the help of a simple real-life example.Answer:Causation is a relationship between two events or states, such that one brings about a changein the other. In short, it explains the cause and effect relationship between two variables or events. Forexample,people who go to college learnskills that are valuable to prospective employers.So acollege degree causes someone’s wages to rise.11.Identify the cause and the effect in the following examples:a.Lower infant mortality and animprovementin nutritionb.A surge in cocoa prices and a pest attack on the cocoa crop that yearAnswer:a.An increase in nutrition is likely to lead to or cause lower infant mortality.b.The pest attack is likely to have reduced the cocoa crop, leading to a rise in prices.

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4Acemoglu, Laibson, and List|MacroeconomicsProblems1.In anepisodeof the sitcomSeinfeld, Jerry and his friends Elaine and George are waiting to be seatedat a Chinese restaurant. Tired of waiting, Elaine convinces the others that they should bribe themaîtred’to get a table.a.What factors shouldtheyconsider whenthey aredeciding howhigh to make their bribe?b.Jerry, Elaine, andGeorge had tickets for a movie after dinner. How would this have affected theamount that they were willing to pay as a bribe?c.The amount that they finally decide to pay is higher than the value of the meal that they wouldhave had. Does this mean that they are being irrational?Answer:a.They should consider the opportunity cost of the time that they will have to spend waiting toget a table. This calculation would depend on how much they value the best alternativeactivity that they could have been doing instead of waiting.b.The fact that they had to catch a movie wouldhaveincreasedtheir opportunity cost ofwaiting.c.Not necessarily.Given that they had already been waiting for a while and had tocatch amovie after dinner, it’s possible that they placed a very high valueon the time that they spentwaiting for the table.Adapted from http://yadayadayadaecon.com/clip/10/2.You are thinking about buying a house. You find one you like that costs $200,000. You learn thatyourbankwill give you a mortgage for $160,000 and that you would have to use all of your savingsto make the down payment of $40,000. You calculate that the mortgage payments, property taxes,insurance, maintenance, and utilities would total $950 per month.Is $950 the cost of owning thehouse?What important factor(s) have you left out of yourcalculation of the cost ofownership?Answer:You have ignored the opportunity cost of the funds you are using for the down payment. Byusing your $40,000 to buy the house,you give up the opportunity to earn interest on that money. Ifyou could earn 5% interest, then the opportunity cost is0.05 x $40,000 = $2,000 per year, or $167 permonth. This does not imply that you should not buy this house. It does imply, however, that you needto think carefully about opportunity cost as you weigh this decision.An economist would tell you thatthe monthly cost of owning this home is $950 + $167 = $1,017.3.You have 40,000 frequent flier miles. You could exchange your miles for a round trip ticket toBermudaover spring break. Does that mean your flight toBermudawould be free?Explain yourreasoning.Answer:It does not. You could use your miles for other travel and so there is an opportunity cost ifyou use your miles to fly toBermuda. Suppose, for example, you are definitely going to fly toChicago when the spring semester is over. You could use your 40,000 miles to fly to Chicago or youcould purchase a ticket for $300. In this case, the opportunity cost of using your miles to fly toBermudais the $300 you will have to spend for the airfare to Chicago.

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Chapter 1|The Principles and Practice of Economics54.You have decided that you are going to consume 600 calories of beer and snacks at a party Saturdaynight. A beer has 150 calories and a snack has 75 calories.a.Create a table that shows the various combinations of beer and snacks you can consume. To keepthings simple, use only round numbers (e.g., you could choose 1 or 2 beers but not 1.5 beers).b.What is the opportunity cost of a beer?Answer:a.Suppose you chooseto consume0 beers. Then you could use all 600 calories on snacks.Since snacks have 75 calories you could consume 600 / 75 = 8 snacks. Now suppose youchoose 1 beer. A beer has 150 calories and so you would be left with 600–150 = 450calories for snacks. You could therefore consume 450 / 75 = 6 snacks if you choose 1 beer.You can use the same logic to complete the table below.BeerSnacks0816243240b.If you consume 1 more beer you will have 150 fewer calories for snacks. Since a snack has75calories,consuming one more beer means that you will have to give up 150 / 75 = 2snacks. The opportunity cost of a beer is therefore 2 snacks.5.Thereis an old sayingthat“The proof of the pudding is in the eating,”which means that by definitiongood decisions work out well and poor decisions work out badly. This question asks you to considerthe wisdom of this saying.a.Your friends live in a city where it often rains in May. Nonetheless, they plan a May outdoorwedding and have no backup plan if it does rain. The weather turns out to be lovely on theirwedding day. Do you think your friends were being rational when they made their weddingplans? Explain.b.You usually have to see a doctor several times each year. You decided to buy health insurance atthe start of last year. It turns out you were never sick last year and never had to go the doctor. Doyou think you were being rational when you decided to buy health insurance? Explain.c.Given your answers to the first two parts of this question, do you agree or disagree that "Theproof of the pudding is in the eating?" Explain.Answers:a.Your friends probably have not optimized, i.e. they were not rational. There was a goodchance of rain on their wedding day and they had no backup plan if it did rain.Given theinformation available when they made their plans, they made a poor decision.b.You probably were being rational when you bought health insurance. You usually have to seea doctor several times each year and without insurance you would have to pay for those visitsto the doctor. Given the information available when you made your plan, you made a gooddecision.

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6Acemoglu, Laibson, and List|Macroeconomicsc.Sometimes the proof is not in the pudding. Sometimes poor decisions work out well (yourfriends live in a rainy city but planned an outdoor wedding); sometimes good decisions workout poorly (you bought health insurance that you never used.6.Consider the following three statements:i.You can either stand during a college football game or you can sit. You believe that you willsee the game very well if you stand and others sit but that you will not be able to see at all ifyou sit and others stand. You therefore decide to stand.ii.Your friend tells you that he expects many people to stand at football games.iii.An economist studies photos of many college football games and estimates that 75 percent ofall fans stand and 25 percent sit.Which of these statements deals with optimization, which deals with equilibrium, and which dealswith empiricism? Explain.Answer:The first statement involves optimization. You believe that you will be best off if you standregardless of the decisions other people make. The second statement involves equilibrium. If manyother people also reason as you did then we should expect many people will decide to stand. The thirdstatement involves empiricism. Our theory tells us that we should expect many people to stand atgames. This economist’s empirical study supports the theory.7.Thecosts of many environmental regulations can be calculated in dollars but the benefits often are interms of lives saved (mortality) or decreases in the incidence of a particular disease (morbidity). Whatdoes this imply about the cost-benefit analysis of environmental regulations?There is an old saying“You can’t put a price on a human life.” Do you agree or disagree? Explain.Answer:We will need to translate the mortality and morbidity data into dollars if we are going tocompare the costs and benefits of environmental regulation. For example, if we knew that a newregulation would impose a cost of $20 million on firms and that it would save one life, we wouldneed to know whether a life is worth more than $20 million or less than $20 million. As ghoulish asthese efforts to place a dollar value on a life may sound, government (and individuals, for that matter)need to make these calculations implicitly or explicitly. There is very substantial economic literatureon the value of a life. Most studies estimate the value of a life in the range of $7 million to $9 million.8.This chapter discussed the free-rider problem.Consider the following two situations in relation tothefree-rider concept.a.The Taft-Hartley Act (1947) allows workers to be employed at a firm without joining the union attheir workplace or payingmembershipfees to the union. This arrangement is known as an openshop. Considering that unions negotiate terms of employment and wages on behalf of all theworkers at a firm, why do you think that most unions are opposed to open shops?b.For your business communication class, you are supposed to work on a group assignment in ateam of six. You soon realize that a few of your team members do not contribute to theassignment but get the same grade as the rest of the team. If you were the professor, how wouldyou redesign the incentive structure here to fix this problem?Answer:a.The free rider problem could explain why unions are opposed to open shops.If a unionnegotiates wages and employment terms on behalf of all the workers at a firm, then eventhose workers who do not join the union will benefit. This means that workers no longer havean incentive to pay union fees as they can free-ride on those who do.

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Chapter 1|The Principles and Practice of Economics7b.Since all the team members get the same grade, an individual team member can free ride onthe work that the others have done.This means that an individualstudent does not have theincentive to contribute to the group assignment.To prevent thisfrom happening, theprofessor can ask students to work on the assignment together but hand in individualpapers.

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Chapter2Economic Methods and EconomicQuestionsQuestions1.What does it mean to say that economists use the scientific method? How do economists distinguishbetween models that work and those that don’t?Answer: The scientific method is the name for the ongoing process that economists and otherscientists use to develop models of the world, test those models with data and evaluate how well theypredict or describe behavior. While this process may not reveal the ‘true’ model of the world, it doeshelp in identifying models that are useful in understanding the world.In order to decide whether models make accurate predictions or not, economists test them againstreal-world data. Data are facts, measurements, or statistics that describe the world. This process oftesting models against data is called empiricism.2.What is meant by empiricism? How do empiricists use hypotheses?Answer: Empirical evidence is a set of facts established by observation and measurement, which areused to evaluate a model. Empiricism refers to the practice of using data to test economic models.When conducting empirical analysis, economists refer to a model’s predictions as hypotheses.Hypotheses are predictions (typically generated by a model) that can be tested with data.3.What aretwo important properties of economic models? Modelsare oftensimplified descriptions of areal-world phenomenon. Does this mean that they are unrealistic?Answer: A good economic model has two important properties. First, it is an approximation. Themodel predicts what would happen on average. Second, it makes predictions that can be tested withdata.A model is a simplified description, or representation, of reality. Because models are simplified, theyarenot perfect replicas of reality. However, this does not mean that they are unrealistic. Models areusually simplified in order to be able to isolate the relationship between two variables. Even if amodel is based on simplified assumptions, it may still help us make good predictions and plan for thefuture.4.How is the mean calculated from a series of observations? Suppose 5,000 people bought popsicles ona hot summer day. If themean of theaverage number of popsicles that each person bought is 2, howmany popsicles were sold that day?Answer: The mean is the average value of a set of observations. It is calculated as the sum of all thedifferent items divided by the number of items.The average value is the sum of all popsicles sold divided by the number of people who bought them.If each of the 5,000 people bought an average of 2 popsicles, that means that 10,000 popsicles weresold that day.

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10Acemoglu, Laibson, and List|Macroeconomics5.How does the sample size affect the validity of an empirical argument? When is it acceptable to useonly one example to disprove a statement?Answer: The size of the sample used to test the argument can affect the results. A small sample maybias the results of a study. A key strength of economic analysis is the amount of data used. Using alarge number of observations strengthens the force of an empirical argument. For example, if youcollect information on consumption from 20,000 people as opposed to 20 people, you are likely to geta more representative result. A single example can be used to contradict a statement. For example, asingle black swan can disprove the statement that all swans are white.6.Explain why correlation does not always imply causation. Does causation always implypositivecorrelation? Explain your answer.Answer: Correlation means that there is a relationship between two variables; as one variable changes,another variable changes. Causation occurs when one variable directly affects another through acause-and-effect relationship. Correlation suggests that there is some kind of connection, but notnecessarily a cause and an effect. For example,thenumber of storks in a region might be correlatedwith the number of babies born in the region. But this doesn’t mean that storks bring babies.Positive correlation implies that two variables tend to move in the same direction. However, causationneed not only imply positive correlation. For example, an increase in the price of bacon may causepeople to buy smaller amounts of bacon. In this example, the price of bacon and the quantity of baconpurchased will show a negative correlation.7.Give an example ofa pairof variables that haveapositivecorrelation,a pairof variables that haveanegativecorrelation, anda pairof variables that have zero correlation.Answer:A person’s IQ and his or her telephone numberare likely to show zero correlation. Thenumber of winter coats sold and the temperature outside are likely to show a negative correlation. Thequantity of fertilizers used and crop yield (e.g., the number of bushels of wheat grown per acre) arelikely to have a positive correlation.8.What is meant by randomization? How does randomization affect the results of an experiment?Answer: Randomization is the assignment of subjects by chance, rather than by choice, to a test groupor control group. Assigning participants randomly will ensure that the result of the experiment is notbiased. For example, suppose students with poor scores are assigned to one type of teaching methodand students with good scores are assigned to another type of teaching method. It will be difficult todecide which teaching method is more effective as the students with the higher scores are likely to dobetter than the students with the poorer scores, irrespective of the teaching method used.9.This chapter discussed natural and randomized experiments.How does a natural experiment differfrom a randomized one? Which one is likely to yield more accurate results?Answer:A natural experiment is an empirical study in which some process–out of the control of theexperimenter–has assigned subjects to control and test groups in a random or nearly random way.The process of randomization involves the assignment of subjects by chance, rather than by choice, toa test group or control group. The test group and the control group are treated identically, exceptalong a single dimension that is intentionally varied across the two groups. The impact of thisvariation is the focus of the experiment. Bothtypes ofexperiments can yield accurate results. Naturalexperiments are likely to be used when there are budget or time constraints to conducting arandomized experiment.10.Suppose you had to find the effect of seatbelt rules on road accident fatalities. Would you choose torun a randomized experiment or would it make sense to use natural experiments here? Explain.

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Chapter2|Economic Methods and Economic Questions11Answer:It would be difficult(and, in many people’s view, unethical)to conduct a randomizedexperiment. Instead, the study should use a natural experiment. You can study data on the causes ofroad accident fatalities incities whereseatbelt rules were not enforced, or in cities that have recentlyadopted new, more stringent seat belt laws. Controlling for other factors like an increase in thenumber of cars, etc., you can then look at similar data when seatbelt rules have been implemented.Problems1.This chapter talks about means. The median is a closely related concept.The medianis thenumerical value separating the higher half of your data from the lower half. You can find the medianby arranging all of the observations from lowest value to highest value and picking the middle value(assuming you have an odd number of observations). While the mean and median are closely related,the difference between the mean and the median is sometimes of interest.a.Suppose country A has five families. Their incomes are $10,000, $20,000, $30,000, $40,000, and$50,000. What is the median family income in A? What is the mean income?b.Country B also has five families. Their incomes are $10,000, $20,000, $30,000, $40,000, and$150,000. What is the median family income in B? What is the mean income?c.In which country is income inequality greater, A or B?d.Suppose you thought income inequality in the US had increased over time. Based on youranswers to this question, would you expectthatthe ratioofthe mean income in the US tothemedian income has risen or fallen? Explain.Answer:a.We can find the mean by summing the observations and dividing by the number ofobservations. So the mean income in Country A is ($10,000 + $20,000 + $30,000 + $40,000+ $50,000) / 5 = $30,000. The median income is the income of the family in the middle of theincome distribution. The median income in Country A is $30,000. Two families have incomebelow $30,000 and two have income above $30,000.b.A similar argument shows that the mean income in Country B is ($10,000 + $20,000 +$30,000 + $40,000 + $150,000) / 5 = $50,000. Median income in B is $30,000; as in CountryA, two families have income below $30,000 and two have income above $30,000.c.Income inequality is higher in Country B. The highest income family in Country B earns$150,000, 60% of the total income in that country. The highest income family in A earns$50,000, just 33% of total income in A. We found that the median income in the twocountries was the same but the mean income was very different. Means will be heavilyinfluenced by extreme values such as the incomes of the very wealthy; median income is lesssensitive to extremes. Economists sometimes use the ratio of the mean to median income in acountry as a rough measure of income inequality; higher values of this ratio reflect greaterinequality.d.You should expect to find that the ratio of the mean to median income has risen. As weargued above, the mean is more sensitive than the median to the incomes of the very wealthy.2.Consider the following situation: your math professor tells your class that the mean score on the finalexam is 43. The exam was scored on a total of 100 points. Does thisimplythat you, too, scoredpoorly on the exam?Answer: The mean is an average value of a set of observations. Although the mean score isrepresentative of the values in the set of observations, a single value (for example, your exam score)

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12Acemoglu, Laibson, and List|Macroeconomicscould be very different from the mean. These ‘outliers’ could skew the mean toward being lower orhigher than most of the other observations. So, it could be possible that you scored higher than, say75,but your classmates’ lower scores pulled the value of the mean downward.3.This chapter stressed the importance of using appropriate samples for empirical studies.Consider thefollowing two problems in that light.a.You are given a class assignment to find out ifpeople’spolitical leanings affect the newspaper ormagazine that they read. You surveytwostudents taking a political science class and five peopleat a coffee shop. Almost all the people you have spoken to tell you that their political affiliationsdo not affect what they read. Based on the results of your study, you conclude that there is norelationship between political inclinations and the choice of a newspaper. Is this a validconclusion? Why or why not?b.Your uncle tells you that the newspaper or magazine that people buy will depend on their age. Hesays that hebelievesthis because, at home, his wife and his teenage kids read different papers.Doyou think his conclusion is justified?Answer:a.The conclusion is not likely to be valid as the sample used in the study is too small.Convincing data analysis will depend on a much larger sample of people. The subjects of thestudy should also be randomly chosen to minimize the possibility of the results being biased.b.This is an example of argument by anecdote. Using a small sample of people to judge astatistical relationship is likely to lead to flawed conclusions. The fact that your uncle’s wifeand kids do not base their reading on their political affiliations does not mean that others donot. In order to arrive at a conclusion, you need to survey more people and also make surethat they are chosen randomly.4.Some studies have found that people who owned guns were more likely to be killed with a gun. Doyou think this study is strong evidence in favor of stricter gun control laws?Explain.Answer: Not necessarily. It is quite possible that people who thought they were at risk (perhapsbecause they live in dangerous neighborhoods) were more likely to buy a gun for self-protection. Thisis an example of a case where correlation may not imply causation. There has been a good deal ofresearch on this question. See, for example, a Harvard School of Public Health 2011 interview withDavid Hemenway (http://www.hsph.harvard.edu/news/features/review-guns-politics-hemenway).5.As the text explains, it can sometimes be very difficult to sort out the direction of causality.a.Why might you think more police officers would lead to lower crime rates? Why might you thinkthat higher crime rates would lead to more police officers?b.In 2012, theNew England Journal of Medicinepublished research that showed a strongcorrelation between the consumption of chocolate in a country and the number of Nobel Prizewinners in that country. Do you think countries that want to encourage their citizens to win NobelPrizes should increase their consumption of chocolate?Answer:a.There is a great deal of evidence that increasing the number of police officers in aneighborhood can drive down crime. The police, for example, will deter criminals whorealize the chances they will becaught have gone up and the police may be able to head offconflicts between gangs. Therefore more police could lead to less crime. Cities strategicallyassign more police to high crime areas (since by definition, those are the areas where crimesare more likely to occur). Therefore, more crime can lead to more police.

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Chapter2|Economic Methods and Economic Questions13b.Correlation does not necessarily imply causation. A strong positive correlation betweenchocolate consumption and Nobel Prize winners does not, by itself, suggest causation. It ispossible that this is a chance correlation. It may also bethecase that certain variables thatcould explain this relationship have been omitted from the study.See the June 11, 2013 New York Times article “Chicago Tactics Put Major Dent in Killing Trend”(http://www.nytimes.com/2013/06/11/us/chicago-homicides-fall-by-34-percent-so-far-this-year.html?hp) on the relationship between police and crime rates. Seehttp://www.reuters.com/article/2012/10/10/us-eat-chocolate-win-the-nobel-prize-idUSBRE8991MS20121010onthe effects of eating chocolate.6.The chapter shows that as a general rule people with more education earn higher salaries. Economistshave offered two explanations of this relationship. The human capital argument says that high schoolsand colleges teach people valuable skills and employers are willing to pay higher salaries to attractpeople with those skills. The signaling argument says that college graduates earn more because acollege degree is a signal to employers that a job applicant is diligent, intelligent, and persevering.How might you use data on people with two, three, and four years of college education to shed lighton this controversy?Answer: If the human capital explanation is correct, then we might expect to find that people whoattend college but do not graduate earn salaries that are close to what college graduates earn. Considerthe extreme case of people who drop out of college the week before graduation. It is very unlikelythat they would have improved their job skills much in that last week. The human capital school ofthought would suggest that they should therefore earn roughly the same salaries as college graduates.On the other hand, the signaling school of thought would argue that these people should earnsignificantly less than college graduates. Employers would interpret their failure to graduate as asignal they are not as diligent or persevering as people who see their college educations through to theend. There is substantial literature on what is often called the “sheepskin effect” (college diplomasused to be written on sheepskin; Notre Dame continued to use sheepskin until 2012). That literaturesuggests that human capital and signaling both contribute to the returns to education that we observein the data.For recent evidence, see the Michael Greenstone and Adam Looney 2013 Brookings Institution study“Is Starting College and Not Finishing Really That Bad?”(http://www.brookings.edu/blogs/jobs/posts/2013/06/07-return-to-some-college-greenstone-looney).They find that people with some college education but who do not graduate from college earn anaverage of $8,000 more per year than high school graduates who never attend college.7.Maimonides, a twelfth century scholar, said,“Twenty-five children may be put in thecharge of oneteacher. If the number in the class exceeds twenty-five but is not more than forty, he should have anassistant to help with the instruction. If there are more than forty, two teachers must be appointed.”Israel follows Maimonides’srulein determining the number of teachers for eachclass. How couldyou use Maimonides’sruleas a natural experimentto study the effect ofteacher-student ratiosonstudent achievement?Answer: Maimonides’srule generates a natural experiment to study of the effect of class size.Suppose School A has 40 third-graders and School B has 41. Following Maimonides’srule, School Awould have one 40-student class while School B would have one 20-student class and one 21-studentclass. Everything else equal, if smaller classes improve achievement then we should expect to seehigher test scores in School B.See Joshua D. Angrist and Victor Lavy “Using Maimonides’ Rule to Estimate the Effect of Class Sizeon Scholastic Achievement,”Quarterly Journal of Economics, 1999(http://qje.oxfordjournals.org/content/114/2/533.full.pdf+html).

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14Acemoglu, Laibson, and List|Macroeconomics8.Oregon expanded its Medicaid coverage in 2008. Roughly 90,000 people applied but the state hadfunds to cover only an additional 30,000 people(who were randomly chosen from the total applicantpool of 90,000). How could you use the Oregon experience to estimate the impact of increased accessto health care on health outcomes?Answer: The Oregon experience is a natural experiment. The state chose people randomly from thepool of applicants, and so on average the new Medicaid recipients were very similar to the peoplewho applied but were turned down. By tracking the health outcomes of people in these two groups wecan study the effect of better access to health care.See “Medicaid Access Increases Use of Care, Study Finds,” New York Times, May 1, 2013(http://www.nytimes.com/2013/05/02/business/study-finds-health-care-use-rises-with-expanded-medicaid.html?_r=0).9.A simple economic modelpredictsthat a fall in the price of bus tickets means that more people willtake the bus. However, you observe that some people stilldo not take thebus even after the price of aticket fell.a.Is the model incorrect?b.How would you test this model?Answer:a.The model is not incorrect. Models are only approximations of real-life behavior.Even verygood models make predictions that are often correct. So, on average, more people will takethe bus. The model is also likely to have made some assumptions, such as no change in costsof other types of transport, or that people have no specific preferences and cost is the onlydeterminant of the mode of transport used. In reality, some of these assumptions may beviolated which could explain why a fall in the price of bus tickets does not induce everyone totake the bus. That does not imply that the model’s conclusion is incorrect. In situations wherethe assumptions it makes are satisfied, its prediction will often be correct.b.The hypothesis here states that as bus prices fall, the number of passengers who take the buswill increase. A natural experiment can be used to test this model. You can use data on pricechanges and changes in revenues earned from tickets to see whether the model is accurate.A1.How would you represent the following graphically?a.Income inequality in the U.S. has increased over the past10years.b.All the workers in the manufacturingsector in a particular country fit into one (and only one) ofthe followingthreecategories:31.5percentare high school dropouts, 63.5percenthave a highschool diploma, and the rest have vocational training certificates.c.The median income of a household in Alabama was $43,464 in 2012,and the median income of ahousehold in Connecticut was $64,247 in 2012.Answer:a.Since the graph needs to show how income inequality increases over a period of time, a time-series graph needs to be used here.b.A pie chart is a circular chart split into segments to show the percentages of parts to thewhole. Since the given data is in percentages, a pie-chart can be used to represent eachcategory of workers.c.A bar chart would be a good way to compare income in Alabama and Connecticut. Theheight of each bar would represent the income ineachone of the states.

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