Solution Manual for Economics Today The Macro View, 20th Edition

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Contents
Part I Introduction
1 The Nature of Economics 1
2 Scarcity and the World of Trade-Offs 17
3 Demand and Supply 31
4 Extensions of Demand and Supply Analysis 47
5 Public Spending and Public Choice 63
6 Funding the Public Sector 81
Part 2 Introduction to Macroeconomics and Economic Growth
7 The Macroeconomy: Unemployment, Inflation, and Deflation 95
8 Measuring the Economy’s Performance 111
9 Global Economic Growth and Development 129
Part 3 Real GDP Determination and Fiscal Policy
10 Real GDP and the Price Level in the Long Run 141
11 Classical and Keynesian Macro Analyses 155
12 Consumption, Real GDP, and the Multiplier 167
13 Fiscal 185
14 Deficit Spending and the Public 201
Part 4 Money, Stabilization, and Growth
15 Money, Banking, and Central Banking 215
16 Domestic and International Dimensions of Monetary Policy 233
17 Stabilization in an Integrated World Economy 249
18 Policies and Prospects for Global Economic Growth 263

iv Miller • Economics Today, Eighteenth Edition
Part 5 Dimensions of Microeconomics
19 Demand and Supply Elasticity 275
20 Consumer Choice 287
21 Rents, Profits, and the Financial Environment of Business 305
Part 6 Market Structure, Resource Allocation, and Regulation
22 The Firm: Cost and Output Determination 319
23 Perfect Competition 333
24 Monopoly 349
25 Monopolistic Competition 363
26 Oligopoly and Strategic Behavior 379
27 Regulation and Antitrust Policy in a Globalized Economy 393
Part 7 Labor Resources and the Environment
28 The Labor Market: Demand, Supply, and Outsourcing 409
29 Unions and Labor Market Monopoly Power 423
30 Income, Poverty, and Health Care 437
31 Environmental Economics 451
Part 8 Global Economics
32 Comparative Advantage and the Open Economy 465
33 Exchange Rates and the Balance of Payments 477
Lecture Extenders 489

Lecture Extender Examples
Chapter 1 The Nature of Economics
The Perceived Value of Gifts
At Christmas and birthdays, aunts, uncles, grandparents, and parents give gifts to their college-aged loved
ones. Joel Waldfogel, an economist at Yale University, surveyed several thousand college students after
Christmas to find out the value of holiday gifts as perceived by the students. He found that CDs and
outerwear (coats and jackets) had a perceived value about equal to their actual cash value. By the time he
got down to socks, underwear, and cosmetics, the students’ evaluation was only about 85 percent of the
cash value of the gift. What argument can be made against the idea of substituting cash or gift certificates
for physical gifts?
Physical gifts show that the giver has gone to the trouble to try to find a gift that will please the recipient.
Such an effort can be viewed as caring, whereas a gift of cash or a gift certificate may not send such a message.
Student Printing in the University
Most universities allow students to use university network printers in student labs when they are working
on the university network as part of their tuition or computer use or technology fees charged to students
when they register for classes. The average school spends several thousand dollars per month for this
service. This service is expensive because students print personal jobs unrelated to academics, such as
downloads from entertainment Web sites and photos of friends and family. Winthrop University in South
Carolina decided to charge students a $10 printing fee that allows them to print 250 pages per semester on
University network printers. After that, the students are charged $0.04 for each additional page that they
print. Assuming students are rational, what do you predict happened to Winthrop’s printing costs after
they implemented this charge? Why?
Winthrop’s printing costs declined by about one-half. Students had been printing some pages that had
little additional value to them because those pages were essentially free. Once each page costs something to
print, rational students printed only those pages that were worth the price charged to them.
Are Economics Students Rational?
If you did a survey in your economics class, not all students would agree with the statement “I am
rational.” In an attempt to show that the rationality assumption is accurate nonetheless, an increasing
number of economists are doing the same kinds of experiments that are used in the physical sciences. One
researcher, David M. Grether, ran some experiments at the University of California at Los Angeles in the
early 1980s. His experiment involved separating students as volunteers into two groups. One group was
paid the same, $7, no matter how it performed. The second group was paid less for poor performance and
more for better performance. This group was paid either $5 or $25, depending on the level of
performance. Performance was measured by how well students were able to pick gambles that had the
greatest probability of winning. Students had to do some relatively complicated math calculations to make
the best guess.
The results were consistent with the rationality assumption. One-third of the students in the group that
was paid regardless of performance picked all of the gambles correctly. In the second group, for which

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490 Miller • Economics Today, Eighteenth Edition
performance was distinctly rewarded, two-thirds of the students had no errors in making their
calculations.
Does the experiment prove that economics students are rational? Why or why not? The experiment does
not prove that economics students are rational, only that the rationality assumption predicts better
performance when the incentive to make the right choice is higher than one that does not. Note that one-
third of the students in the better-rewarded group did no better than did the majority of the uniformly paid
group.
Incentives and Childhood Obesity
Children who gain weight eat more calories than they use up each day. The ones who gain weight the
fastest eat relatively more high-calorie foods such as hamburgers, French fries, and other fast foods. They
also exercise less, preferring to spend more of their time watching TV and playing video games rather
than playing out doors and participating in sports.
Traditionally, mothers have taken responsibility for making the choices about what foods children eat and
the scope of their outdoor activities. As compared to the 1960s, when about one-half of mothers worked
outside the home, more than three-fourths do so today. These mothers have less time to keep their
children from eating too much, e.g., in the hours after school before getting home from work, and to take them
to playgrounds to exercise. This helps explain why only 8 percent of children whose mothers have never
worked outside the home are obese as compared to 17 percent among children whose mothers work full-
time. It is important to realize that children have always had an incentive to eat sweet snacks and tasty
high-calorie foods and engage in sedentary activities; it is now also true that parents have economic
incentives that affect the choices they make that affect the time available to devote to child rearing. Finally,
our society has developed a taste for bigger houses with more expensive furnishings and bigger, more
expensive cars.
From an economic standpoint, is it possible that some parents effectively make a choice to have bigger,
more expensive houses, cars, furnishings, and overweight children? (Hint: To be able to purchase bigger,
more expensive houses, cars, and furnishings, parents must spend more time earning incomes and less
time rearing their children.) Yes. By making the decision to have bigger houses and cars and more
expensive furnishings, some parents are also choosing to supervise their children’s eating habits and
activities less. Thus, they are choosing to let their children become obese.
Incentives and the Internet
It is worth examining the idea that changes in incentives cause people to change their behavior. In recent
years, the cost of some types of high-speed Internet service has declined to as little as $20 per month for
unlimited access to the Internet. This means that people who use their high-speed connection primarily
for surfing the Web for information and e-mail pay exactly the same amount per month as do gamers and
people who download music and videos. The first group uses very little bandwidth, and the second group
uses very high amounts of bandwidth. Recently, some Internet service providers (ISPs) have put forth the
idea that the monthly fee for high-speed Internet service be for a specific amount of bandwidth use. After
that bandwidth has been used by a customer, a fee would be charged on additional bandwidth use. What do
you expect this form of pricing by ISPs for bandwidth would do to the volume of video and music
downloads from companies such as iTunes and companies that provide movies over the Internet? The
volume of such downloads and thus sales of high bandwidth applications would decrease because the price
of each additional downloaded movie or song would go from being essentially free under the current
pricing scheme to having a positive price after the initial amount of bandwidth sold with the Internet
service had been used.

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Lecture Extender Examples 491
Getting Directions
Suppose that you plan to take a trip from San Diego to San Francisco and you have never made this trip
before. You could use Google Maps and it would tell you to get on Interstate 5 going north until you get
to San Francisco. Alternatively, suppose that you want to get to a specific address in San Francisco. In
this case, Google would give you a map that tells you to get on Interstate 5 going north until you get to
San Francisco. At this point, it would give you the freeway exit number needed and a detailed street map
that would allow you to drive to the address you have chosen.
How does a map resemble a model and the realism necessary of that model? A model should capture only
the essential relationships that are necessary to analyze a problem at hand. Thus in the first case of getting
from San Francisco to San Diego, a very simple map (model) that has almost no detail is adequate for
your purpose. In the second case, considerably more detail (more realistic) is required.
Chapter 2 Scarcity and the World of Trade-Offs
Why Today’s College Bands Get Less Playing Time
At a college basketball game with only 25 seconds left, the home team, which is behind by 1 point,
steals the ball and calls time-out. As the home team’s band director gets ready to play part of the school’s
fight song to get the fans fired up behind the team, she gets a message over her headset telling her that
there is one more commercial to do before the game ends. As the scoreboard flashes the name of a local
bank, the gym’s 110-decibel sound system blares out a prerecorded voice describing the bank’s low
interest rate loans and top-notch customer service. The commercial then ends just before the play begins.
Across the nation, college athletic departments have found that they can charge up to $15,000 per minute
to advertisers for a commercial played to the fans at the arena. Thus, many bands find that they are getting
to play less—even in 15-second segments called “shorts”—because even 15-second commercial time
slots can be sold to advertisers. If the average minute of time at a college game can be sold for $10,000
in advertising revenues, what is the opportunity cost to the college of a 15-second band “short?” Fifteen
seconds is one-fourth of a minute. Thus, the opportunity cost of a 15-second “short” is one-fourth of
$10,000 or $2,500.
The Controversy over Offshore Drilling as a Reaction to
Higher Gasoline Prices
In 2008, the price of gasoline rose to over $4.00 per gallon, and diesel climbed to more than $5.00 per
gallon. At the same time there was a presidential election in which this development became one of the
major issues. The Republicans favored rescinding a ban on offshore drilling for oil in most waters around
the United States except for the Gulf of Mexico, while the Democrats largely opposed lifting the
moratorium. According to the Federal Energy Information Administration, an estimated 18 billion barrels
of oil in the area are covered by the moratorium.
What is the opportunity cost to the economy of a decision to prohibit offshore drilling for oil? The
opportunity cost to the economy is the 18 billion barrels of oil.
Continued Life versus the Environment
In the 1990s, it was discovered that taxol, a chemical found in the bark of Pacific yew trees in the Pacific
Northwest, was effective in treating ovarian cancer, which afflicts 10,000 women each year. It takes the
bark of about 150,000 yew trees per year to extract enough taxol to treat these women, many of whom
would otherwise die. The problem is that yew trees are slow growing and are mostly in old-growth forests
that have taken hundreds of years to develop. Taxol has recently been found to be effective on a number

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492 Miller • Economics Today, Eighteenth Edition
of other cancers, such as lung cancer. This has increased the demand for it and thus results in more trees
being required. Even the development of a semisynthetic version of taxol does not completely solve the
problem. Complete synthesis is not yet economic. Environmentalists point out that heavy logging of old-
growth forests can damage other trees and the environment, generally. Until scientists develop new
sources of taxol, there will continue to be a trade-off: Saving women with ovarian cancer and persons
with other types of cancer or saving Pacific yew trees.
What is the opportunity cost of saving yew trees? What is the opportunity cost of saving the lives of the
women suffering from ovarian cancer who could be treated with taxol? The opportunity cost of saving
yew trees is the costs associated with the early death of women from ovarian cancer. The opportunity cost
of saving those lives is the loss of yew trees and damage to old-growth forests. Because the number of
Pacific yew trees is finite and limited to a small area, the yew trees could become extinct.
Do all environmentalist attempts at saving plants or animals involve an opportunity cost? Yes, all
environmental attempts to save plants and animals involve an opportunity cost because resources must
be used to save them or some resources may not be used if the plant or animal is to be saved. In all cases,
resources have alternative uses. Those that are used to save a plant or animal cannot be used for
something else. If a resource cannot be used so that a plant or animal can be preserved, then we must give
up the highest-valued alternative thing for which it could have been used.
The Opportunity Cost of Going to College
What is the cost of going to college? The obvious costs are the costs of tuition, fees, and textbooks. The
obvious costs of going to college do not include room and board because these costs will be incurred no
matter what you do—go to work or go to school. The biggest cost of going to college is forgone income.
This is to say that going to college usually means sacrificing a full-time salary. In the case of a typical
18-year-old, the opportunity cost of going to college may be $15,000 to $20,000 per year. The cost to a
pop country singer such as Taylor Swift would have been nearly $60 million this year. For Justin Bieber,
it would have been $55 million. For the successful musician, actor, or model, the old saw “Get all the
education you can get” doesn’t make much sense.
Opportunity cost has something to do with the decision by Taylor Swift and Justin Bieber not to attend
college while they are under the age of 25. Between the ages of 17 or 18 and 25, the opportunity cost of
going to college for stars in the popular music industry is very high.
What is the opportunity cost of leaving college early for student athletes who join professional teams prior
to graduation? The opportunity cost of leaving college early is the forgone education. If at the end of a
professional career the athlete does not have a degree, then his or her best income alternatives will usually
be much lower than for an athlete who did get a degree.
Small-Business Entrepreneurs Create Most New Jobs for New Workers
Small-business entrepreneur-headed companies employing 500 or fewer workers account for about
99.7 percent of all U.S. businesses and employ nearly half of U.S. workers. Entrepreneurs’ efforts to
create new small enterprises or to expand existing businesses account for between 1 million and 3 million
new jobs each year. As a consequence, the enterprise-establishing and business-expanding efforts of
entrepreneurs account for about 75 percent of the net increase in U.S. employment.
Why do states with laws promoting entrepreneurial activity, such as Arizona, Colorado, and Oklahoma,
typically experience the largest employment gains each year? Laws promoting entrepreneurial activity
must mean that these state governments make it easier and less costly to establish and operate a business
in these states. There is an incentive therefore for entrepreneurs to establish businesses and to expand
existing ones where it is less costly to do so.

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Lecture Extender Examples 493
The Opportunity Cost of Time Stuck in Traffic
Every year motorists spend about 3.7 billion hours waiting in gridlocked traffic. Policymakers commonly
argue that the explicit cost of time spent in traffic jams—at least $6 billion spent on the $2.3 billion gallons
of fuel burned while engines idle—is sufficiently high to justify building more highways. The implicit
opportunity cost is much higher. The average U.S. worker earned about $24.5 per hour in 2012, so the
implicit opportunity cost of all those hours spent in traffic is around $91 billion per year. Thus the annual
total social cost of U.S. traffic gridlock is more than $97 billion.
Why do economists use the hourly wage to measure the opportunity cost of the time a person spends in
gridlocked traffic? Because that is the market value of a person’s time, economists assume that this will
be the minimum value that a person will put on alternative uses his/her time, or he/she would choose to
work.
Chapter 3 Demand and Supply
Congestion Pricing for San Francisco
San Francisco and other cities are examining congestion pricing, which has been successfully used in
European and Asian cities, as a way to reduce traffic congestion. In London, for example, drivers were
initially charged an $8 fee, which has since increased to $14, every time they enter London’s central
business district. Before the congestion fee was implemented, traffic congestion was a major problem in
central London. The effect of the congestion fee was to reduce traffic congestion by nearly a third in three
years, as measured by traffic speeds. Traffic speed has nearly doubled from about 5 mph during business
and rush hours to about 10 mph as a result of a decrease in the number of motor vehicles entering central
London. Use of public transportation into the area increased significantly after the fee went into effect.
Does the decrease in the number of vehicles entering central London represent a decrease in demand or
a decrease in quantity demanded for the use of central London’s streets? It is a decrease in the quantity
demanded because the price of using the streets has risen from $0 to $14. Thus, there has been a
movement along the demand curve for the use of the streets for driving in a motor vehicle.
U.S. Agricultural Subsidies and Globalization
The U.S. government began subsidizing U.S. cotton farmers in the twentieth century to allow them to stay
in business. The purpose was to insulate them from fluctuating market prices that could bankrupt cotton
farmers as a result of world market conditions beyond their control. The farm lobby has made sure that
cotton remains a subsidized product, protecting to some extent cotton farmer income.
The cotton subsidies of the United States (and other developed countries) are alleged to be a major reason
why cotton farmers in India are experiencing declining income and many are being forced out of
farming. The world price of cotton has fallen by more than 33 percent since the mid-1990s. The Indians
blame the United States and other developed countries’ subsidies for these lower prices. Thus, a program
aimed at helping U.S. farmers is driving Indian farmers out of business.
Are the Indian farmers right to blame the cotton subsidies for their plight? Yes. The United States and
developed country subsidies increase the world supply of cotton and decrease its price, other things held
constant.

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494 Miller • Economics Today, Eighteenth Edition
Is Dental Care Becoming an Inferior Good?
A British health minister once claimed that the demand for health care is infinite because everyone is in a
losing battle against death. This is not so for American dentistry, however. As aggregate U.S. income levels
have risen during the last 25 years, overall spending on dental care services has declined.
It is not that fewer Americans are seeing dentists each year. They just do not require as many fillings or
extractions. As incomes rose, people purchased more expensive and effective toothpastes. More towns,
cities, and counties began to fluoridate their water as the relative price of this anticavity agent declined,
so changing relative prices have played a role. The higher incomes of their residents have permitted more
municipalities to purchase fluoridation systems. At every age, the average American now has two more
teeth than 25 years ago.
Many fledgling dentists have begun specializing in “cosmetic dentistry” desired by clients with healthy
but less than beautiful teeth. Compared to traditional dental-care services, is cosmetic dentistry more or
less likely to be a normal good? Cosmetic dentistry is more likely to be a normal good. As incomes rise,
people are likely to wish to improve their appearance because they can afford the expense.
The Global Financial Crisis and the Price of Oil
In the summer of 2008, the price of oil reached a peak of $147 a barrel, with gasoline reaching more than
$4.00 per gallon in much of the United States. The global financial crisis struck in September 2008, which
ushered in a worldwide recession. The price of oil fell to below $60 per barrel, and gasoline fell to less
than $2.00 per gallon in much of the United States. Recessions result in large numbers of people losing
jobs and thus having reduced incomes. Do oil and gasoline appear to be normal goods? The demand for a
normal good will increase when buyer income increases and decrease when buyer income decreases.
Because a recession means lower buyer income, the decrease in the prices of oil and gasoline would be
due to a decrease in demand caused by a decrease in income, ceteris paribus. Thus, oil and gasoline are
normal goods.
Brunettes Now Have More Fun
In the 1960s, manufacturers of hair dye aired TV commercials claiming that “Blondes Have More Fun” and
“Gentlemen Prefer Blondes.” For years thereafter, purchases of blonde hair colorings were a significantly
higher share of total U.S. dye purchases. In the early 2000s, women’s tastes began to change. More top
female stars of stage and screen are brunettes. In addition, the numbers of Asian, Hispanic, and Arabic
women, who are largely brunettes, has increased. Finally, graying women in the aging Baby Boomer
generation find that darker colors cover gray better and require less maintenance.
What do you suppose has happened to the demand for brunette hair dyes in the 2000s? What about the
demand for blonde hair dyes? As tastes have moved in favor of brunette hair, the demand for brunette hair
dyes has increased. As tastes have moved against blond hair dyes, the demand for blonde hair dyes has
decreased.
Thai Gadget Makers Raise Production When LCD Prices Fall
Beginning in 2004, the prices of liquid crystal displays (LCDs), which are key components in many
electronic devices, fell significantly. As LCD prices fell, Thailand-based manufacturers of electronic
devices, such as cell phones, hand-held computers, portable DVD players, and laptop computers that all
use LCDs, increased production.
What do you think happened to the prices of these devices that use LCDs? Why? The lower price of an
important input such as LCDs would have increased the supply of these devices. Ceteris paribus, the
price of each device would have decreased.

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Lecture Extender Examples 495
Chapter 4 Extensions of Demand and Supply Analysis
OPEC and Oil Prices
In July 2008, the price of oil increased to $147 per barrel. By October, it had fallen to around $60 per
barrel. OPEC saw the price of their major export, oil, decrease by 60 percent in a few months. During that
period the OPEC countries cut production by a little more than 2 million barrels per day. By mid-
November, the price had fallen below $60 per day. OPEC announced in November that it would cut
production again if the price did not stabilize at a reasonable level of $70 to $90 per barrel.
Assuming that OPEC decreased the supply of oil by more than 2 million barrels per day over a two-
month period, why would the price of oil continue to fall? The demand for oil must have been decreasing
faster than supply was decreasing.
Jamaica’s Sugar Industry Takes a Hit
Sugar production in Jamaica amounts to a little more than a third of the country’s exports. The country
could sell its sugar in the European Union (EU) at a price three times higher than the world market price.
Under an agreement reached with the World Trade Organization in 2009, the EU agreed to cut the sugar
subsidy by 36 percent over the next four years. The result is an expected price that would seriously harm
Jamaican sugar producers who are not competitive at the world market price of sugar.
Using the supply and demand model, explain how the reduction in the EU sugar subsidy would affect the
price of sugar paid to the Jamaicans. The effect of the subsidy is to increase the supply of sugar produced
by Jamaican producers. The EU would decrease the subsidy paid to Jamaican producers, and the effect
would be the same as a decrease in the price received by them for their sugar. The supply of Jamaican-
produced sugar would decrease, and the price would decrease, other things, constant.
Why Ships Face Traffic Jams
In most U.S. ports, docking fees, which are fees charged to ship owners for the right to dock and load and
unload passengers or freight, are set by government agencies. In recent years, the demand for docking
space at U.S. seaports has increased as the number of cruise ships and number of pleasure cruises have
increased. Neither the prices charged to dock a ship nor the amount of docking space have changed as
demand has increased. What kind of price control has been placed on docking space for ships? A price
ceiling that does not respond to changes in demand has been imposed.
What effect do you expect the price ceiling combined with an increase in demand for dock space has had?
A shortage of docking space has developed because the price space for docking a ship has not risen to the
market-clearing level.
Movements in Supply and Demand
It’s not often that a doubling of demand leads to a 25 percent reduction in price. That is exactly what
happened in the underwater fiber-optic cable business. This is a perfect classroom example.
The demand for underwater fiber optic cables doubled in 2003 and continued to grow in 2004 and 2005.
In contrast, rates of capacity utilization in the undersea fiber-optic business have hovered around 10 to
15 percent during the first half of the 2000s. Consequently, fiber-optic cable owners were willing to reduce
prices quite substantially in order to “light up” some “dark” fiber-optic cable capacity. That is to say,
supply could move out to the right almost at will in that industry.

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496 Miller • Economics Today, Eighteenth Edition
This is a good example of showing the supply curve moving outward faster than the demand curve moved
outward. Given that the demand doubled and prices fell by 25 percent, you can demonstrate this with a
relatively large shift in the supply of undersea fiber-optic cable utilization.
Profiting by Lowering the Transaction Costs of Junking Computers
Having a computer that is so out-of-date that it cannot be adapted or at least easily adapted to modern
software can create problems for its owner. Most states have laws against throwing computers away
because they contain toxic metals and other potentially harmful sources of pollution. As a result, for fees
ranging from a few to $50 or more, middlemen will take old computers and refurbish the ones that can be
upgraded for resale and break the others down for parts that can be resold. In this way middlemen profit
from reducing transactions costs for consumers faced with discarding old computers.
What would happen to the demand for the services of computer-recycling middlemen if computer
manufacturers found a way to produce computers without pollution-causing components? The demand for
their services would decrease (possibly to zero) because it would be possible to simply throw away an
obsolete computer at no cost to the owner.
Preventing Price Gouging Promotes Black Markets in Florida
In many states, including Florida, it is illegal to engage in price gouging. Florida’s law penalizes a seller
for any “gross disparity between the quoted price of a ‘necessity item’ such as water, and the item’s price
on the date that the governor declares a state of emergency.” The penalties stay in force for 30 days from
the date of the declaration. Florida is susceptible to hurricanes, and in 2004, three successive hurricanes
struck Florida. The demand for “necessities,” such as bottled water, gasoline, and plywood increased
significantly because damages to the state’s housing, electrical grid, and businesses were extensive. With
prices fixed at prehurricane levels, there was little incentive for producers and others outside the state to
rush these items to the Florida disaster areas.
Who gains and who loses when antigouging laws contribute to shortages of items such as bottled water or
plywood? The buyers who are able to buy water and plywood at below market-clearing prices gain by not
having to pay the market-clearing price. Those buyers who are unable to buy water and plywood at
current prices and who would be willing to pay the market-clearing price lose because the market does
not supply enough of these goods at the antigouging price (ceiling price). Sellers lose because they earn
lower profits than they could have made by selling more of these goods at a higher price.
Price Controls in Sierra Leone
Lisa Walker spent a year in Sierra Leone, West Africa, as a Peace Corps volunteer, and she kept a diary
of her experiences. One thing she wrote about was what happened when the government imposed price
controls on many common items. “For the past 5 days,” she wrote, “nobody has sold cigarettes, kerosene,
Maggi (bouillon) cubes, or rice here . . . This is the result of the government’s new order. The government
says the Maggi cubes have to be sold for 30 cents, but the sellers bought them for 50 cents, so when
military men enter the village to enforce the government price, those with Maggis hide them. It is the
same story for cigarettes and kerosene. The rice supplies are hidden because of government prices. Unless
one is willing to pay an outrageous price, it is impossible to buy rice in the marketplace. The only way to
get rice legally is to buy it from the government. This means standing in long lines for many hours to get a
rationed amount. I don’t know how Sierra Leoneans are managing or how long this artificial shortage will
last.”
How would you graphically illustrate the market for rice in Sierra Leone in the presence of price controls?
The supply of rice would become vertical at the price ceiling and quantity supplied by the government.

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Lecture Extender Examples 497
There would be a shortage at the legal price. The equilibrium price would occur at the intersection of the
demand curve and the vertical portion of the supply curve.
Should the Legal Quantity of Cigarettes Be Set at Zero?
Nicotine has been used as a psychoactive drug by the native peoples of the Americas for approximately
8,000 years. Five hundred years ago, Christopher Columbus introduced tobacco to Europeans, who
discovered, once they overcame the nausea and dizziness produced by snorting, chewing, and smoking
it, they simply could not get along without it. Nicotine rapidly joined alcohol and caffeine as one of the
world’s most popular psychoactive drugs. In the century after Columbus returned from the Americas with
tobacco, consumption and addiction to nicotine spread rapidly around the world. There followed
numerous attempts by governments to quash what had come to be called the “evil weed.” None were
successful, even in Russia where a smoker could be executed for using it. A few years ago, the head of
the Food and Drug Administration announced that his agency had concluded that nicotine is addictive and
should be classified with marijuana, heroin, and cocaine.
What can we predict if tobacco is ever completely prohibited? Because tobacco is now legal, the supply
of illegal tobacco is zero. If the use of tobacco were prohibited, the legal supply in the United States
would become zero. Even if all of those who had been producing tobacco legally went out of business,
firms in foreign countries would increase production to meet U.S. demand. The supply curve of illegal
tobacco products would shift to the right. There would be an illegal tobacco demand curve from U.S.
users of tobacco. The price people would pay would go up.
What other goods or services follow the same analysis as the ones presented here? The psychoactive
drugs such as marijuana and cocaine were all legal around the turn of the century. The illegal supply was
zero. When these drugs were outlawed, that is, the legal supply was set at zero, illegal demand developed,
and the illegal supply increased. The price of these psychoactive drugs increased. The same analysis can
be applied to prostitution and gambling services.
Chapter 5 Public Spending and Public Choice
Trying to Lay Claim to Trees That Sop Up Pollution
American Electric Power (AEP) owns power plants around the United States that together release about
3 percent of U.S. CO2 emissions every year. The company has entered into a voluntary agreement with
the U.S. government to cut its CO2 emissions by 1 percent every year. AEP has determined that it would
cost between $50 and $75 per ton of eliminated emissions to build cleaner power plants. In contrast,
planting a sufficient number of CO2 absorbing trees would cost only $1 to $2 per ton of emissions.
AEP faces two problems in utilizing trees to reduce the polluting effects of its power plants. One is
uncertainty about how much CO2 trees absorb from the air. The company has already spent more than
$17 million to reforest nearly 60,000 acres of land near its U.S. power plants and paid more than
$7 million to protect a 4-million acre forest in Bolivia. AEP projects that over several decades, the new
U.S. trees alone will sop up 11 million tons of CO2 or the amount that its power plants release in 16 months.
Independent and government scientists disagree, however, about whether these estimates are accurate.
The second problem is that property rights to CO2 tree absorptions are poorly defined. It is unclear, for
instance, how much pollution-reducing credit AEP will be able to claim from its investment in Bolivian
forests if Bolivian polluters try to also lay claim to the pollution abatement benefits those forests provide.
Under what circumstances could society come out ahead if AEP and other polluters planted trees instead
of cleaning up any of their power plants? If companies could have ownership rights to the trees they

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planted, they would plant the trees because fewer resources would be used to clean up air pollution. These
resources could instead be used to produce other goods and services. The external costs of pollution
could be internalized at minimum cost. Also, there would be an increase in the quantity of wood
produced.
The Global Financial Crisis
In 2008, the Federal Reserve lowered interest rates and the federal government implemented a tax rebate
program as the U.S. economy began to show signs of entering a recession. Later in the year, the Federal
Reserve provided very large amounts of money to the financial markets and banking system as the
financial markets began to collapse, to prevent a much more serious recession or depression from
developing.
Which function of government was the Federal Reserve and the federal government performing? The Federal
Reserve and federal government were performing the function of ensuring economy-wide stability, which
includes preventing recessions to ensure full employment and to promote economic growth.
Hydrogen-Based Fuel Cells
In his State of the Union address in 2003, President Bush supported the idea of changing from the use of
internal combustion engines to fuel cells based on hydrogen as a way of reducing air pollution and the
emission of greenhouse gases. Fuel cells are nonpolluting because they only emit water vapor. President
Bush proposed having the government subsidize research and development of hydrogen fuel and fuel cell
technology. The president did not propose raising taxes on gasoline as a way of encouraging the use of
fuel cells and reducing greenhouse gases.
Would an increase in the tax on gasoline encourage the development of hydrogen-based fuel cell technology
for automobiles? A tax that accounted for all external costs associated with gasoline emissions would
increase the price of gasoline and make operating a gasoline-powered car more expensive. Thus, there
would be an incentive for auto companies to develop and sell fuel cell–powered cars because consumers
would find these cars relatively cheaper to operate. The demand for fuel cell–powered cars would
increase and the demand for gasoline-powered cars would decrease.
Office of Homeland Security
After the events of September 11, 2001, an Office of Homeland Security was set up to try to coordinate
the antiterrorism efforts of various agencies of the federal government. In 2002, the Homeland Security Act
was passed, creating the Department of Homeland Security. Two components of the mission of the
Department of Homeland Security as set forth in the act are to “prevent terrorist attacks within the United
States and to reduce the vulnerability of the United States to terrorism.” The department evaluates
intelligence concerning potential terrorist threats and issues alerts when the danger of terrorist attacks
appears to be imminent. In addition, it works with law enforcement and emergency service agencies in the
states and cities to help prepare for terrorist threats.
Does the part of the mission of the Department of Homeland Security identified above describe the
provision of a public good? The part of the mission identified appears to be a public good. First, it is a non-
rival good. The use of it by one person does not decrease the availability of it to another person. Also, it is
subject to the exclusion principle, i.e., once it is produced, no one can be excluded from enjoying its
benefits, even if they do not pay for it. It is indivisible and would be difficult to price based on how much
a person uses it.

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Private Property Rights in China
In 1949, China officially became a “People’s Republic” in which all resources were owned by the
government. For nearly 30 years, the Chinese government made all decisions concerning the production
and distribution of goods and services. Beginning in the 1980s, the Chinese government embarked on a
gradual program of business privatization. This policy resulted in an increase in economic growth.
Nevertheless, government and business leaders eventually recognized that China’s economy would be
unable to obtain its full potential in the absence of a formal declaration of private property rights. An
amendment to the Chinese constitution officially guaranteeing the right to private property was adopted in
2004. How might the establishment of private property rights have contributed to a burst of Chinese
economic growth in the past few years? (Hint: Why might clearer rules about resource ownership make
people more willing to start businesses?) Once property rights were established, entrepreneurs knew that
their right to possess, use, enjoy the benefits of its use, and transfer of their property would be protected
by the government.
This assurance provided an incentive to start businesses. For those who had been running businesses, as
well as new entrepreneurs, the establishment of private property rights would have provided an incentive
to use their property efficiently. The effect would be to cause the establishment of more businesses and
encourage efficiency. The output of goods and services would be predicted to increase faster.
Microsoft Antitrust Suit
In 2002, a four-year-long lawsuit against Microsoft by the Department of Justice was settled. The Department
of Justice alleged that Microsoft had illegally maintained a monopoly in the operating systems market and
had used that monopoly to attempt to monopolize the Internet browser market by tying purchases of
Internet Explorer to purchases of the Windows operating system. The company was found by the court to
have illegally maintained its virtual monopoly over computer operating systems and to have attempted to
monopolize the browser market. Microsoft agreed to no longer engage in its restrictive business practices.
Which economic function of government was being performed in this example? Are there any benefits to
the economy from the settlement of this case? The economic function of government being performed in
this case is promoting competition. By preventing Microsoft from continuing to maintain its monopoly of
PC operating systems and attempting to monopolize the browser market, the government hoped to
increase efficiency in the market for operating systems and to prevent the loss of efficiency in the browser
market.
Canada Opts Out of Paying for North American Missile Defense
The North American Aerospace Defense (NORAD) system uses satellites and ground- and air-based
radar systems to detect attacks aimed at the United States and Canada. In the past, both countries paid for
the operation of NORAD. When the United States asked Canada to help finance a new missile defense system
that would supplement NORAD’s activities, the Canadian government declined in part because the proposal
was politically unpopular with Canadians.
They become public goods because the principle of rival consumption does not apply to them. Thus, it
becomes possible to be a free rider because if the defense system is provided at all, then a country that
does not pay for it can still be protected.
Property Rights Resolve the Airport Wi-Fi Spillover
To encourage U.S. travelers to use their facilities, various U.S. airports have installed Wi-Fi systems that
allow travelers to use Blackberries and laptops to access the Internet and e-mail accounts. Several airlines
had set up their own wireless communication systems to process passenger tickets and to track luggage
before the airports had installed their WI-Fi systems. When the airport Wi-Fi systems started operating, their

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500 Miller • Economics Today, Eighteenth Edition
radio signals interfered with some of the airlines’ wireless communications systems, causing ticketing and
baggage data transmissions to be garbled or blocked. At the same time, transmissions from the airlines’
wireless systems had the same effect on the airports’ Wi-Fi systems. Under the airlines’ contract with the
airports, the airports had the right to use the frequencies on which conflicts had arisen. Thus, the airlines
had to incur the costs to recalibrate or replace their systems entirely to eliminate wavelength “pollution”
created by competing systems.
Why is it that an external cost would be created if transmissions from a company’s Wi-Fi system garbled
the signals of the wireless computer networks in a nearby residential neighborhood? In the process of
using its Wi-Fi system, the company is imposing uncompensated costs on the wireless computer networks
in the nearby neighborhood. In effect, the company’s “electronic pollution” spills over and makes the
other wireless computer networks useless.
Chapter 6 Funding the Public Sector
How State Trucking Fees Push Up Highway Maintenance Costs
Oregon is the only state that bases highway fees charged to truckers on the amount of weight carried per
truck axle. Having more axles better distributes cargo weight and reduces pressure on the highway,
minimizing wear and tear on the roads. Thus, Oregon’s system of highway fees gives truckers who haul
freight only within Oregon an incentive to drive trucks with more axles, thereby reducing damage to the
state’s roads and helping hold down state highway spending. In contrast, every other state bases highway
fees on a truck’s fuel consumption. Driving trucks with fewer axles reduces tire friction on the road
surface, which increases fuel efficiency and thereby reduces the fees truckers must pay to use highways.
Naturally, freight haulers in states outside of Oregon have an incentive to drive trucks with fewer axles.
As a result, roads in these states suffer greater damage, which in turn, ultimately generates more spending
on highway maintenance.
If a trucking firm based in Oregon sends most of its trucks on long-distance trips outside the state, is it
more likely to use trucks with four or five axles? The Oregon trucking company would use trucks with
four axles because they would pay most of their taxes and fees on fuel. Their fuel costs and total costs
would thus be lower.
States Seek to Tax Internet Sales
According to the National Governors Association (NGA), failure to collect sales tax on online sales
results in annual tax revenue losses of at least $35 billion. State governments are unable to apply sales tax
rates to most Internet orders for out-of-state goods and services, but this has not stopped them from trying
to do so after the fact. Twenty state income tax forms now have a line on which taxpayers are supposed to
report sales taxes owed on out-of-state purchases. To get people to report out-of-state purchases, states
threaten audits that would uncover credit card records.
Why do you suppose that most states with lines on tax forms that require taxpayers to report taxes due on
out-of-state purchases do not audit every taxpayer who chooses to leave the line blank? (Hint: Engaging
in any activity, including conducting audits of taxpayers entails an opportunity cost.) It is most likely that
most taxpayers who leave the line blank have no tax to report, or at best only a small amount that can be
proved. The tax revenue return from auditing all of these returns would require a large expenditure of
state revenues that could be used for higher priorities.

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Lecture Extender Examples 501
Eastern Europe Discovers Proportional Taxation
In most nations, income tax systems are progressive. Nevertheless, governments in several Eastern European
nations have recently opted for proportional taxation. Most of these nations were formerly part of the Soviet
Union, such as Russia and Estonia, or were satellites, such as Romania. Beginning in the mid-1990s, the
governments of Estonia, Lithuania, and Latvia introduced tax systems that apply the same income tax rate
to all levels of income. The Russian government established a proportional income tax system in 2001.
Since then, the governments of Serbia, Ukraine, Slovakia, Georgia, and Romania have followed suit.
What is true of average and marginal tax rates in Eastern European countries that have adopted
proportional income tax systems? The marginal and average tax rates are equal.
Paying for Social Security via a Broadened Payroll Tax
Professionals such as doctors and lawyers who are self-employed pay a Social Security payroll tax rate of
15.3 percent on the first $113,700 of income or $17,396 in Social Security tax. If one of them earned
more than $113,700, the tax on the additional income would be zero. Recently, there have been proposals
to help solve the long-term funding problem in Social Security by charging the tax on all earned income.
As an example, suppose a lawyer made $1,000,000 per year. Currently, she would pay a maximum
amount of $17,396 in Social Security tax. Under the proposal to subject all earned income to Social
Security tax, she would pay $153,000 in tax.
To avoid paying a higher tax bill, the lawyer could establish an “S corporation” and work for it as an
employee. She could pay herself a salary of $113,700 and limit her Social Security tax to $17,396. The
rest of her annual income would be reported in the form of corporate profits. Based on current tax laws,
she would have to pay income tax on her salary and the corporate profit, but the corporate profit is not
subject to Social Security tax.
Does it matter for estimating the actual increase in the Social Security tax actually collected whether static
or dynamic tax analysis is used? Yes. Static analysis simply takes the higher Social Security tax rate and
multiplies it by the amount of earned income that currently is above the maximum subject to tax, i.e., on
the tax base, to determine the estimated tax revenue to the government. Dynamic tax analysis takes into
account the existence of “S corporations” and the ability of self-employed persons with high incomes to
take advantage of them to avoid the higher Social Security tax payments, i.e., to shrink the tax base.
Chapter 7 The Macroeconomy: Unemployment, Inflation,
and Deflation
The Nobel Prize for Economics and the Natural Unemployment Rate
The winner of the Nobel Prize for economics in 2006 was Edmund Phelps, who developed the concept of
the natural rate of unemployment. His original argument was that the economy will not reach equilibrium
until the rate of unemployment reaches its “natural rate.” This natural rate means a rate of unemployment
in which all long-run forces work themselves out in the economy and it is in long-run equilibrium.
Specifically, Phelps was concerned with the role of inflationary expectations and that these will eventually
coincide with the actual rate of inflation. The idea is that there is a rate of unemployment that is in effect
an equilibrium rate toward which the economy tends to move. It is not, however, a fixed rate that holds for
all time. Phelps argued that the natural rate of unemployment would depend on different factors in
different economies.

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502 Miller • Economics Today, Eighteenth Edition
How is the natural rate of unemployment related to the concept of full employment? The natural rate of
unemployment is full employment that exists when there is no cyclical unemployment. It is the rate of
unemployment that is the sum of structural and frictional rates of unemployment.
Are a Self-Employed Dad and a Daughter Who Is Not Working
Part of the Labor Force?
Johnson is a self-employed painter. On most days, he paints room interiors alone. From time to time,
however, he has taken on exterior house-painting jobs, which pay implicitly higher hourly rates.
Whenever he has tackled home exteriors, he has usually hired his daughter, who will be 18 years old next
week, to help after school. Johnson has not landed an exterior painting job in a couple of months, so he
has not required his daughter’s assistance during that time.
Johnson is hoping to expand his thriving painting business into a larger operation. To learn more about
how to function in the business world, he is taking business courses at the local community college in the
evenings. Currently, he is enrolled in a course in principles of macroeconomics, and his class has just
discussed how the labor force and the unemployment rate are measured. Now Johnson is wondering
whether his daughter is technically part of the labor force but unemployed. She just graduated from high
school and had been actively looking for a job until about a week ago, when she gave up looking any
further. In fact, Johnson is not even certain whether he, as an actively self-employed individual, is currently
included as an employed member of the labor force.
Is Johnson’s daughter currently part of the labor force but unemployed? No. While she does not have a
job, she stopped looking for a job last week. Thus, she is not officially unemployed.
Is Johnson currently part of the labor force and employed? Yes. As an actively self-employed individual
he is part of the labor force. He has a “thriving painting business.” He must therefore be employed.
How the Word “Unemployment” Found Its Meaning
Until the late nineteenth century, people in the United States were not acquainted with the word
“unemployment.” The failure of able-bodied people to find work in a largely agricultural country with
so much plentiful land was usually regarded as an indication of laziness, not misfortune. During the
booming industrialization of the latter half of the nineteenth century, about one-half of the native-born
population and nearly all immigrants got jobs in manufacturing and transportation industries. Then a financial
panic in 1873 generated thousands of business failures, and many thousands of workers found themselves
without gainful employment.
Statisticians conducting the 1878 census in Massachusetts decided that they had to come up with a category
for all the people who had become jobless so abruptly. They settled on the term “unemployment,” which
they ultimately defined as working-age individuals “out of work and seeking it”—the same definition
used today.
Would unemployment as we understand it exist today if everyone was self-employed? No. A person
could be out of work due to decreases in demand for the product he/she used to make. The person could
not be seeking a job in the modern sense because by definition no one would be hiring.
Recessions and the Electoral Blame Game
As a result of the recession that began in 2007 and continued into 2009, the unemployment rate rose to as
high as 10 percent. By the time of the presidential and congressional elections of 2012, the economic
recovery was under way, but the unemployment rate was still around 8 percent. The Republicans saw this
as evidence that the Democrats’ economic policies had failed to deal with the lasting effects of the

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Lecture Extender Examples 503
recession. They, in fact, blamed the lasting high unemployment on the policies of the Democrats and
President Barack Obama.
The Democrats and President Obama pointed to increasing real gross domestic product (GDP) as evidence
that the economy was fundamentally sound and was no longer in a recession. Both parties could not be
right—either the economy had entered a period of expansion and the policies of the Democrats were
working and they should get credit for it (whether deserved or not), or had not but had in fact contributed
to continuing high unemployment.
Why do you suppose that one party can at the same time be blamed for not really ending a recession and itself
take credit for ending a recession? The actual change in economic activity from a recession to an expansion
(or vice versa) involves changes in a large number of variables from negative to positive. The Democrats
were correct in stating that an expansion was under way. However, the fact that the unemployment rate
dropped only slightly from its highest point in the recession supported the notion that the Democrats’
economic policies were ineffective in dealing with unemployment as measured by the unemployment rate.
Thus while concentration on one or two measures of economic activity by one party will not definitively
identify the beginning of a recession or expansion, it can be effective politically. For example, despite an
increase in total employment, the unemployment rate may not change because of an unexpected increase
in re-entrants and new entrants to the labor force, as was the case in 2012.
Deflation and Real Interest Rates in Japan
Around the turn of the century, wholesale and consumer prices fell in Japan. In 2002, for example,
consumer prices fell by 0.4 percent. Short-term interest rates averaged around 0.1 percent. Assuming
that the 0.4 percent decrease in the price level was anticipated in Japan, the real interest rate was at
0.5 percent. This is computed by adding the expected rate of deflation to the nominal interest rate.
Why can’t nominal interest rates be negative? A negative nominal interest rate implies that a lender will
pay a borrower to borrow money. A lender could choose not to lend and have more wealth at the end of
any time period by not lending. His or her consumption and thus satisfaction would be higher.
How Reliable Is the CPI?
The CPI is a fixed-quantity price index, meaning that each month the Bureau of Labor Statistics samples
only prices rather than relative quantities purchased by consumers. The problem is that when relative
prices of particular goods go up, consumers substitute in favor of other relatively less expensive items.
When relative prices go down, consumers do the opposite. An important way that consumers deal with
inflation is by buying less of products that become “too expensive.” The result is that the rate of inflation
is overstated.
Would there be a similar problem during a period of deflation? During a period of deflation, consumers
would substitute goods that experience a decrease in relative price for other relatively more expensive
ones. Because a fixed-weight price index such as the CPI ignores this effect, it will understate the rate of
deflation.
Chapter 8 Measuring the Economy’s Performance
How the Internet Has Contributed to a Lower U.S. Inventory-to-Sales Ratio
In the 1990s, there was widespread adoption of just-in-time inventory techniques by U.S. businesses, which
are techniques that companies use to keep inventories from running out or building up beyond desired
levels. The Internet has facilitated the implementation of many just-in-time inventory techniques. When a

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504 Miller • Economics Today, Eighteenth Edition
company that supplies basic components used in a variety of electronic products experiences an inventory
buildup, it has several options for reducing its inventory via the Internet. The company could offer some
of its inventory for sale on organized business-to-business exchanges that handle total transactions
exceeding $1 trillion per year. In addition, it could use computer programs offered by Ariba and
Commerce One to operate its own Internet auctions to sell its inventory to the highest bidders.
Alternately, the company can purchase the Web-auction services of eBay or other firms to assist in selling
off some of its inventory.
Considerable evidence shows that the use of the Internet-based just-in-time inventory techniques have
contributed to the noticeable decline in the ratio of inventories to sales in U.S. manufacturing. In 1990,
the inventory-to-sales ratio was about 1.75, which means that U.S. companies had about $175 in
inventory for every $100 in sales. Sixteen years later the ratio had fallen to 1.35.
What effect would this decline in the inventory-to-sales ratio have had on U.S. inventory investment? It
would have decreased the amount of inventory investment because the average firm would have
decreased its holdings of inventory by $40 for every $100 in sales in 2006 as compared to 1990.
GDP and Economic Welfare
Gross domestic product, or GDP, has become the most important measure of how well the economy
performs. It is used by policymakers, economists, international agencies, and the media as the primary
measure of a nation’s economic health and well-being, but it was not designed for this role. It is the sum
of the value of final products and services produced in one year by domestic resources, with no
distinctions between transactions that add to well-being and those that diminish it. In the computation of
GDP, it is assumed that every monetary transaction involving the production and sale of final goods and
service adds to the nation’s well-being.
GDP ignores everything that happens outside the realm of the production and market exchange of final
goods and services, regardless of its importance to well-being.
Would GDP increase when the environment is damaged by toxic spills and then the damage caused
by these spills is cleaned up? Yes. The clean up of toxic sites would increase GDP because resources
would be employed to clean it up. These resources would be providing final services to the economy.
The productive activity that led to the spills would also be counted in GDP.
Would the country actually have an increase in well-being as a result of the pollution and the clean up
activities? No. The pollution initially reduced well-being. Cleaning it up simply restored the environment
to its original state and the earlier level of well-being.
GDP and Costa Rica’s Forestry Production
Many developing countries depend on natural resources for much of their income and employment. When
a forest is cut down in Costa Rica, the output is sold, and if we look only at GDP figures, the economy
appears to be growing richer. But what if the trees are not replaced so that their removal results in
flooding, soil erosion, and loss of fuel and food by the indigenous population? Robert Repetoo of the
World Resources Institute in Washington, D.C., has recalculated GDP in Costa Rica to reflect the impact
of resource depletion. His figures show that within the forestry sector itself, net forestry product—after
resource depletion is calculated—was actually negative through most of the 1980s. Repetoo argues that
such statistics are important because they educate the developing countries and show them that their
natural wealth is not limitless. He wants the United Nations to take into account the depletion of natural
resources when calculating each nation’s GDP. He points out that currently, a benefit from commercial
forests is recorded only when trees are cut down.

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In the United States, there are actually more trees in our forests than there were 50 years ago. Does this
mean that we should be adding to our GDP figures for this increase in our forests? We should not be
counting these additional trees in current GDP. Using current definitions, trees in a forest are intermediate
goods rather than final goods because the trees are not consumed as final goods until they are cut down
and processed into forestry products that are in some final product.
The Importance of Distinguishing Between Real GDP and Nominal GDP
Suppose that you are advising a presidential candidate in an election campaign running against the
incumbent president for the opposing party who points out that GDP has risen in every quarter since she
has been in office. The president is using this information to argue that that the voters should reelect her
because her administration’s policies have led to prosperity for the last four years. You notice during two
periods of her administration the unemployment rate rose significantly for several months. The
unemployment rate can increase while economic activity is increasing for a variety of reasons. Still, you
wonder whether the candidate is talking about GDP figures that are adjusted for price level changes or
not.
Would it be possible for nominal GDP to increase in every quarter of this president’s administration if
real GDP decreases in some of them? Real GDP could have decreased and nominal GDP increased if the
price level increased by more than enough to offset the decline in real GDP. For example, if real GDP had
decreased by 2 percent and the price level had increased by 5 percent, then nominal GDP would have
increased by 3 percent.
What the GDP Figures in China Really Mean
For years, the Western world has been regaled by impressive figures on the growth in the Chinese economy.
Whereas the United States has been happy with growth rates of 3 and 4 percent per year, the Chinese
economy has been growing at 7, 8, even 9 percent per year. But what do such statistics really mean? One
Chinese economist in Beijing, Lu Feng, compared China’s official production rate of meat, eggs, and fish
products with what people actually consumed. He concluded that real output in these sectors had been
exaggerated by more than 40 percent. The reason is that officials want to show good output performance,
so they overstate agricultural output. The same problem plagues the industrial sector. The reality is that so
long as China does not correct its reported output figures by doing many sampling surveys, it is bound to
exaggerate its real GDP and thus its economic growth.
Why do government statisticians in the United States not face a similar problem? In the United States,
good performance by private producers is measured by profitability and not by total output. Thus, U.S.
producers do not have any incentive to overstate output.
Chapter 9 Global Economic Growth and Development
Productivity Growth in the United States since 2002
Productivity is the major driver of economic growth in the United States, accounting for about half of the
increase in real GDP over time. Between 1996 and 2001, productivity showed no trend and averaged
about 2.7 percent. In 2002, productivity increased to 4.1 percent and then declined to 1.0 percent by 2014.
The average growth rate for productivity in this period was 1.9 percent. This development caused concern
about such factors as higher inflation and slower economic growth. If productivity continued to decrease,
then the resulting slower rate of economic growth would mean smaller increases in real wages and
standards of living in the future.

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506 Miller • Economics Today, Eighteenth Edition
By how much more would output per labor hour and real GDP have increased in this six-year period if
productivity growth had averaged 4 percent per year instead of 3 percent per year? (Hint: The productivity
growth figures have been rounded off for use with Table 9-3.) If productivity growth had averaged 4 percent
per year, output per labor hour would have increased by 27 percent. Real GDP would have increased by
one-half of that amount or 13.5 percent, other things held constant. If productivity growth had averaged
3 percent per year, output per labor hour would have increased by 19 percent. Real GDP would have
increased by one-half of that amount, or 9.5 percent, other things held constant.
Is Official Labor Productivity Overstated?
According to the U.S. Bureau of Labor Statistics (BLS), U.S. labor productivity has increased by nearly
40 percent since 2000. To obtain the data used to create labor productivity measures, the BLS surveys
businesses about their output of goods and services and the average weekly hours of full-time employees.
When constructing its labor productivity measure, the BLS excludes government employees, self-
employed people, managers, and part-time and temporary employees. Recent estimates indicate that
including these forms of labor might reduce the growth in U.S. labor productivity by as much as one-half.
Why might the output of government workers be difficult to gauge for purposes of measuring labor
productivity? Government workers usually do not produce discrete units of output that are sold in the
market. Thus getting an output measure to divide by hours worked would be difficult or in some cases
impossible.
The Productivity Paradox
In the course of a book review he wrote in 1987, Nobel economist Robert Solow made the offhand
comment, “You can see the computer age everywhere but in the productivity statistics.” This comment
summed up what has become known as the “productivity paradox”: the seeming lack of productivity
gains from information technologies. For example, widespread adoption of information technologies in
service industries was supposed to allow these industries to reap big efficiency gains. Bar coding of
merchandise was supposed to allow sales clerks at retailers to do their work much more efficiently.
Financial electronic data interchange was supposed to provide big productivity enhancements in financial
services. These productivity gains were slow to emerge—either that or the data are wrong.
Higher education is a good example of a service industry. College campuses are now full of computers.
How would you propose to measure the effect of computers on productivity in higher education?
There are two places where it might be possible to measure productivity in higher education. One area is
in administrative services, e.g., the registration process, student record keeping, payroll, etc., which are
done faster and with fewer person-hours than would be the case in the absence of computers. This is
clearly the case with the advent of computerized test banks. At one time, departmental secretaries and
other clerical personnel typed many, if not most, tests. Today, faculty members choose the questions as
they always did but have the computer generate the final copy of the test. Fewer clerical hours are used to
support the teaching function. Insofar as the actual delivery of education by university faculty is
concerned, the use of semester credit-hours produced or number of students enrolled to measure
productivity (output per faculty member per hour in the classroom) probably is not an appropriate
measure of education. On that basis, the only way for productivity to increase would be to increase class
size. Another way would be to measure how much additional learning occurs as a result of better teaching
materials, student access to vast libraries on the Internet, skills acquired in using computers that better
prepare students for future careers, and more efficient methods of presenting material (presentation
software, for example).

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Economic Growth in China and India Accelerates
China has per capita GDP levels that are well below those of the United States. The Chinese per capita
GDP in 2014 was $11,868 in 2014 dollars compared to the United States of $54,678 also in 2014 dollars.
The Chinese growth rate of per capita GDP averaged 7.5 percent from 2000 to 2014, while that of the
United States was 2.0 percent (source: data.un.org). Assume that China’s growth rate of per capita real
GDP falls to 6 percent indefinitely. If the U.S. growth rate of per capita real GDP fell to 0 percent, how
long would it take China to catch up to the United States? (See Table 9-3.) Currently, U.S. per capita real
GDP is 4.6 times larger than China’s. At a growth rate of 6 percent, $1 grows to $5.74 in 30 years. Thus,
it would take China slightly more than 30 years to reach the current level of U.S. per capita real GDP
even if the United States stopped growing for that time period.
Japan and Germany Save and Invest More Than the United States,
But Does It Matter?
Japan and Germany have saving rates that are substantially higher than the U.S. rate. As a result, they
have accumulated more capital. On a per capita basis, Japan has about 22 percent more invested capital
than the United States, and Germany has 13 percent more. Nevertheless, the United States creates more
wealth per capita. In 2000 dollars, the United States created $29,950 in new wealth per capita, compared
to $23,600 for Japan and $23,600 for Germany.
At least part of the difference results from more efficient use of capital in the United States. Economists
estimate that a unit of capital in Germany or Japan generates output that is about a third lower than that in
the United States. In other words, if a $1,000,000 factory produces 1,000,000 units of output per year in
the United States, a comparable factory would produce about 670,000 units of output per year in Germany
or Japan.
Some claim that “Americans over consume, undersave, and underinvest.” How do the figures here
counter this statement? Americans get a return on investment in output terms that have the effect of a one-
third increase in saving and investment as compared to Germany and Japan. On that basis, one cannot say
that Americans underinvest (and thus undersave) because the consequences of investment are greater here
than in Germany and Japan. On a comparative basis, the effect of Japan’s greater capital investment per
capita is effectively 33 percent − 22 percent = 11 percent less than in the United States, while Germany’s
investment per capita is effectively 33 percent − 13 percent = 20 percent less than in the United States.
The Labor Productivity Boom in Manufacturing
Among the industries that manufacture physical goods, labor productivity has increased steadily over the
years. In many manufacturing industries, production tasks that once took two weeks and a dozen workers
to finish now require only a few hours to complete. Since the 1950s, therefore, labor productivity has grown
nearly three times faster than the rate of growth of productivity in the rest of the economy. Annual U.S.
manufacturing output is five times higher than in the 1950s, even though total employment in
manufacturing—about 16 million—is the same as today.
U.S. employment has more than doubled since the 1950s, so what happened to the percentage of workers
employed in manufacturing jobs? The percentage of workers employed in manufacturing jobs has decreased
because the number of persons employed has doubled. The same number of workers in manufacturing is a
smaller percentage of total employment.
Our High-Tech Economy
Four decades ago, one in six American businesses was automotive-related. In 2012, autos and light trucks
accounted for about 2 percent of GDP. So does spending on computers and related equipment. Yet despite
the fact that technology’s share has doubled in the last decade, government statisticians still refuse to use

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508 Miller • Economics Today, Eighteenth Edition
chip inventories and personal computer sales as economic indicators. The reason is that the economic
welfare created by high-tech industries is much harder to measure than, say, tons of steel or bushels of
corn.
When software is distributed at no charge on the Internet, does that result in an increase in GDP? There
would be no effect on GDP because no market price is charged.
Chapter 10 Real GDP and the Price Level in the Long Run
Investment and Long-Run Aggregate Supply in the Great Recession
Between the second quarter of 2006 and the second quarter of 2009, real gross private domestic investment
fell in all quarters except the second quarter of 2007 at an average annual rate of 11.5 percent. During that
time period, depreciation exceeded real Gross Private Domestic Investment (GPDI).
What effect did having depreciation exceeding GPDI have on U.S. long-run aggregate supply curve?
Because capital was not being replaced, the capacity of the economy to produce goods and services would
have decreased. Thus, the long-run aggregate supply curve would have decreased.
Regulation and Economic Growth
If the extent of federal regulation activities in U.S. product and labor markets can be measured by the
sheer volume of published regulations, then the scope of regulation has increased by more than 500 percent
since 1950. To satisfy heath and safety, environmental, labor, and various other regulations, companies
must shift resources away from producing goods and services. Consequently, the regulation of economic
activities entails an opportunity cost for society: forgone production of real GDP.
John Dawson of Appalachian State University and John Seater of North Carolina State University have
estimated the degree to which federal regulations have reduced real GDP growth. They have calculated
that the trend rate of annual growth of real GDP is almost 1 percentage point lower due to regulatory
growth. Thus if there had been no increase in federal regulations since the early 1950s, the economy’s
long-run aggregate supply curve would have shifted much further to the right over the past five decades.
U.S. real GDP would be at least 40 percent higher today.
How do various activities involved in satisfying federal regulations get counted in real GDP?
(Hint: Income payments must be made to owners of resources directed toward meeting regulatory
requirements.) The value of the activities involved in satisfying federal regulations would increase
GDP since they generate income to the resource owners who supply the information. These costs are
included in the prices of goods and services produced by the firms who are required to meet the
regulations.
The Financial Crisis, Long-Run Aggregate Supply and Inflation
In the fall of 2008, the financial markets suffered a major crisis that led to a large decrease in the willingness
of banks and other financial institutions to lend either to each other or to consumers and businesses. Much
of the investment in capital in the United States is financed by borrowing. Many businesses were unable
to borrow. During this time, the capital stock decreased as worn-out capital was not replaced.
What would the effect on the rate of inflation be if aggregate demand recovers to its prerecession level?
The inflation rate would increase. During the recession, the decrease in the capital stock caused the long-
run aggregate supply curve to shift to the left. Thus, the price level would increase to a higher level at the
same prerecession level of aggregate demand.

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Lecture Extender Examples 509
Corporations Adjust to Potential and True Deflation
For decades, the conventional wisdom among corporate financial officers was that they could lower their
companies’ costs by financing purchases of capital by borrowing—taking out loans from banks, selling
commercial paper, issuing new bonds, and the like. The reason is that debt has traditionally been less
expensive to a firm than issuing new shares. Corporate managers count on inflation to erode the value of
the firm’s debts even as the selling price of the company’s output increased.
In a deflationary environment, however, these dynamics are reversed. Deflation increases the real value
of outstanding debts. At the same time, companies find that to repay their loans, they must dip into profits
that are declining. In 1997 and 1998, companies based in Southeast Asia faced lower selling prices and
mounting real values of their indebtedness. In addition, the relative values of their currencies fell, and
many of their debts were denominated in dollars. Thus in addition to a rising real value of their debts in
local currency, they also had to use more units of it to buy dollars to pay off their dollar indebtedness.
In the past few years, U.S. manufacturing companies have been seeing their selling prices declining.
Corporate treasurers in these industries are now talking about a new balance sheet paradigm in which
companies will rely much more heavily on issuing stock instead of borrowing.
In what ways might deflation affect an individual’s well-being? For persons who are creditors, deflation means
an increase in the real value of the debts owed to them as well as increases in the purchasing power of the
interest payments. For example, a retired person with certificates of deposit and shares in a bond mutual
fund should experience a net increase in both wealth and his or her standard of living. Debtors will find
that they are worse off because they will have to pay off debts in dollars that are worth more in
purchasing power terms than the ones they borrowed. In a practical sense, the debt repayments will be
made from a lower dollar income for the average debtor because a falling price level means lower dollar
incomes on the average. So, someone paying off a car loan over a five-year period would find him- or
herself giving up increasing amounts of purchasing power.
Chapter 11 Classical and Keynesian Macro Analyses
An Antiterrorism Regulation Creates an Aggregate Supply Shock
In August 2002, President George Bush signed the Trade Act, which, among other things, created a new
set of transportation security rules aimed at reducing the likelihood that terrorists would smuggle weapons
into the United States. The new rules apply to every mode of transportation—trucks, trains, ships, and
planes—and require these transportation companies to send e-mails or faxes notifying the Bureau of
Customs and Border Protection of the contents of all cargoes and the intended recipients. The purpose
is to give officials time to identify suspicious shipments so that they can intercept and inspect them for
contraband. The advance notice varies with the type of transportation, ranging from 30 minutes for trucks
to 24 hours for ships.
Large trucking companies had electronic systems to direct deliveries, so they made costly modifications
to them to send automatic messages to government officials. Smaller companies incurred greater costs
because they had to make rapid transitions to electronic systems or buy fax machines and incur much
higher long-distance phone charges. The two-hour notification requirement for international cargoes
required FedEx and similar companies to have to restructure aspects of their overnight delivery
systems. Freight train operators and owners of cargo ships also had to make expensive changes in their
record-keeping procedures. The effect was to increase shipping prices for U.S. companies using imported
components for their products. These companies also had to make adjustments in their inventory
management systems to take into account regulation-induced shipping delays. Over time, the effects on
shipping costs and inventory management costs diminished.

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510 Miller • Economics Today, Eighteenth Edition
What was the effect on the short-run aggregate supply curve of the Trade Act? Explain. The short-run
supply curve decreased. In addition to higher shipping costs, the delays caused by the Trade Act would
have meant that firms would have had their goods and/or resources tied up in the inspection process. As a
consequence, the delays would have slowed deliveries. Thus, the payments for these goods and services
or resources that could have been used to produce goods and services would have been idle during the
delays. In either case, firms would have been able to produce less with the same resources as a result of
the delays associated with the inspection process.
How Sticky Are Prices in the United States Economy?
Mark Mils and Peter Klenow, in a 2004 paper, “Some Evidence on the Importance of Sticky Prices,” in
the Journal of Political Economy, made a study of how often prices change in the U.S. economy. What
they found is that in the U.S. economy, the median time between time and price changes (excluding
temporary price changes such as sales and specials) was 8 to 12 months. It is also the case that service
prices change less often than goods prices, and prices of goods that use a high proportion of raw materials
change more often, as do prices of unprocessed food items.
Suppose that there is a supply shock, such as the increase in oil and other energy prices that occurred after
Hurricane Katrina. In less than a year, these prices fell from their high point in the fall of 2005, as Gulf
Coast refineries were brought back online and much of the damage to Gulf oil and gas production was
repaired. The price of oil did not fall all the way back to summer 2005 levels, but this was due to other
factors such as cutbacks in production by OPEC and a continuation of rising demand for oil by China and
India in 2006. Also, there was relatively little change in the U.S. rate of inflation in late 2005 and 2006.
If Mils and Klenow’s work is correct, why didn’t the inflation rate increase in 2006 as a result of the Katrina
supply shock? If prices do not change in the economy more often than every 8 to 12 months, then the short-
run aggregate supply curve will not shift upward immediately following a supply shock. In fact, it should
take at least 8 to 12 months before it shifted upward. During the adjustment time, the price of oil and
other energy declined. The price of oil and other energy products did not stay at their highest levels long
enough to permanently affect the price level.
Drilling for Offshore Oil
In 2010, the Obama administration implemented more restrictive regulation of oil exploration and production
in the areas just offshore of the United States. The cost of drilling offshore oil wells is likely to increase
significantly as a result. Based on current assessments, these areas have an estimated 18 billion barrels of
oil. As a result of the environmental catastrophe associated with the British Petroleum oil spill in the Gulf
of Mexico, considerable controversy surrounds developing these oil resources. Environmentalists argue
that the effect on a fragile ocean ecosystem makes drilling and pumping oil from these locations too
costly. Thus, they strongly oppose drilling there.
What will happen to the long-run aggregate supply curve (LRAS) as a result of the implementation of
these more restrictive regulations on drilling for offshore oil?
Assuming that regulation increases costs and reduces drilling activity, the effect would be to shift the
LRAS curve to the left. The reason is that the United States would have decreased supply of oil available
to the U.S. economy.
Banning Women from the Labor Force: The Case of Afghanistan
In the mid-1990s, the Taliban seized power in Afghanistan after 18 years of war and proclaimed a
fundamentalist Muslim state. This strict Muslim state existed until the Taliban government was
overthrown in 2002 by the U.S. military and the Northern Alliance. As part of the Muslim principles as

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Lecture Extender Examples 511
interpreted by the ruling clerics, women’s activities were severely restricted. Women and girls were
forbidden to go to offices and schools. The restriction on gainful employment was particularly painful for
women who were sole supporters of their families. After 18 years of war, there were many fewer men to
support families.
It was estimated that women made up 10 percent of the labor force before the Taliban seized power so
that the prohibition on women working reduced the labor force by 10 percent.
What would have happened to real GDP and the price level after the Taliban took over Afghanistan?
Explain using aggregate demand–aggregate supply analysis. Real GDP would have decreased both long-
and short-run aggregate supply because the labor force would have decreased. Given the aggregate
demand curve, real GDP would have decreased. The aggregate supply curves would intersect the
aggregate demand curve at a higher price level.
Chapter 12 Consumption, Real GDP, and the Multiplier
The Financial Crisis of 2008 and the U.S. Saving Function
In the fall of 2008, the global financial crisis set off fears of a recession. As the financial markets and
stock prices collapsed, households, fearing a recession, began to save more. The Keynesian model
predicts that the result of households increasing saving to protect themselves from the expected recession
can actually cause a recession to occur.
How would it be possible for increased saving to cause a recession to occur in the Keynesian model?
Explain using the simple fixed price level Keynesian model. If households increase saving, they cause the
saving function to shift upward. As a result, the consumption function shifts downward and the C + I + G
+ net exports function shifts downward. The equilibrium level of real GDP decreases, other held things
constant, causing a recession.
Changes in Wealth and Consumption
In the third quarter of 2008, the financial markets collapsed along with the housing market where housing
prices began falling after 2008 and continued into 2011. Could this fact explain the slow recovery of
consumption spending?
Yes. The continuing decrease in housing prices has decreased consumer wealth. Thus, even after personal
income began growing again in the third quarter of 2009, the decrease in household wealth would have
resulted in a downward shift of the consumption function.
Is the U.S. Rate of Investment Understated?
Investment is measured in the national income accounts as the sum of spending on physical capital—
plants and equipment, infrastructure, and housing—and adjustments to inventories of produced goods.
Using this definition, the portion of U.S. real GDP allocated to investment lags behind much of the rest
of the developed world. Some economists worry that the result is that total planned expenditures are
depressed along with equilibrium income. In addition, these economists are concerned that the lower rate
of investment reduces the rate of capital accumulation and reduces economic growth.
Other economists believe that the current definition of investment fails to capture the true meaning of the
term. Most of measured investment spending is on capital, i.e., resources used to produce output in the
future. There are at least three other types of expenditures that appear to fit this definition, which are not
currently included in investment. The first is education, which yields returns over long periods of time.
Much of educational spending is for investment in human capital. Currently, only spending on schools

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512 Miller • Economics Today, Eighteenth Edition
and educational equipment are included in investment spending. The United States allocates nearly
7 percent of real GDP to education. In most other countries, it is 5.5 percent or less. Second is spending
on research and development (R&D). R&D expenditures are counted as government consumption and
private production costs. It is clear that R&D expenditures aid economic growth. The United States
allocates about 3 percent of real GDP to R&D, while most other countries allocate 2 percent or less.
Finally, consumer durables yield a stream of services over a number of years, yet only housing is counted
as investment in the national income accounts. U.S. households spend about 6 percent of real GDP for
other durables that yield service flows for years.
Another factor in comparing the U.S. investment rate with that of other countries is that U.S. investment
goods are less expensive. That is, a given dollar of spending on factories or equipment provides more
units of these goods in the United States as compared to other countries.
When all of these factors are taken into account, the adjusted measure of investment of the United States
exceeds 35 percent per year, while the average rate adjusted the same way for other industrialized countries
is about 30 percent.
The MPC and the Multiplier in the United States
A significant issue from 2009 to 2012 was the problem of slow economic growth after the recession that
began in late 2007. An important problem was predicting what would “get the economy growing” fast
enough to get out of a “jobless recovery.” Part of the issue could be viewed as the amount of new spending
that would be needed. The multiplier concept would be useful in determining the answer to this problem.
The multiplier concept appears to suggest that the MPC, and thus the multiplier, is constant over time, so
that the size of a given change in autonomous spending will have a predictable effect on equilibrium real
GDP. According to the national income and product tables given by the Bureau of Economic Analysis
for real GDP and personal consumption expenditures (PCE) in billions of 2005 dollars for the years
2009–2012 are:
Year Real GDP PCE
2009 12,758 9,032
2010 13,063 9,196
2011 13,299 9,429
2012 13,616 9,630
As an economic analyst, you could use these figures to determine the simple multiplier to predict given
changes in autonomous spending.
Instruct students to compute the MPC for the years 2009–2010 and for 2011–2012. What would be the
values of the simple multiplier for these two time periods? MPC between 2009 and 2010 is the change in
consumption (PCE) of $164 divided by the change in real GDP of $305 or 0.54. Between 2011 and 2012,
the change in consumption (PCE) of $201 divided by the change in real GDP of $317 or 0.63. The
resulting simple multipliers 1/(1 − MPC) would be 1/(1 − 0.54) = 2.16 for 2009–2010 and 1/(1 − 0.63) =
2.73 for 2011–2012.
Why would a stable multiplier be necessary to come up with the appropriate change in autonomous
spending? Would these simple multipliers help if they were correct for the economy as a whole? If
the simple multipliers shown were the correct ones for the economy, they would not provide much
guidance for a person trying to determine how much of a change in autonomous spending would be
needed. A stable multiplier would be needed to be able to predict the effect of a given change in
autonomous on the equilibrium level of real GDP.

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Lecture Extender Examples 513
Chapter 13 Fiscal Policy
Direct Offset of Government Grants
Private companies fund a considerable amount of scientific and engineering research. So does the
government. Although some of this research is conducted by people directly employed by government
agencies, the government also helps fund research by providing grants to researchers. Many such grants
provide dollar payments directly to researchers to fund all or part of their salaries and those of their
assistants. In addition, the government often helps pay for special equipment for various research
facilities.
Since 2000, the number of full-time researchers using funds provided by government grants has risen by
9 percent. Total federal outlays for research and development have increased by more than 45 percent. In
the absence of government grants, a portion of this growth in research funding would have been provided
by the private sector. This helps explain why the government’s share of total national spending on
research and development has risen from 25 percent to about 35 percent today.
How might increased government spending on research and development that simply replaces private
spending dollar for dollar affect aggregate demand? It would result in no change in aggregate demand
because the increase in government spending would be exactly offset by an equal decrease in planned
private spending on research and development.
The U.S. Government Finds an Unexpected Leak in Its Stream of Tax Revenues
Most federal tax revenues come from income taxes. Therefore, to predict its tax collections accurately, the
U.S. government must accurately forecast GDP. The government has never performed this task very well,
however, so its tax revenue projections are notoriously inaccurate. Another problem has emerged in the
2000s that caused it to overpredict its income tax collections. Under U.S. tax laws, workers pay taxes on
income they receive via paychecks or direct deposits to their bank accounts. They do not, however, owe
income taxes on any portion of their incomes that is withheld to pay for their contributions to employer-
provided health plans. Before 2002, workers’ incomes and health benefit contributions typically increased
at the same pace from year to year. After 2003, this pattern changed. Many workers agreed to accept
lower wage and salary increases in exchange for enhanced health benefits. Nontaxable worker
contributions to health care plans rose twice as fast as taxable incomes. The result was a smaller increase
in total taxable earnings than the government had forecast. Consequently, the government overstated the
amount of income tax revenues that it would collect.
In the debate concerning the new national health care bill passed, some congressmen proposed making
health care benefits taxable. What would be the likely effect of such a plan on aggregate demand? Total
income taxes paid by workers would increase, so aggregate demand would decrease as the workers’
disposable income decreased.
The Effects of the Bush Tax Cuts
In 2001, the Bush administration was faced with a recession and a budget surplus. Keynesian economic
policy suggested that the use of an expansionary fiscal policy could counter the recession. The Bush
administration chose to cut taxes because this was also a policy that it had campaigned on in 2000. The
tax cuts did, in fact, provide a stimulus to the economy in the short run. The tax cuts also were designed
to shift the largest sums of tax savings to upper income groups because the Bush administration used the
supply-side economics argument that these tax cuts would stimulate saving and thus investment. The
result would be economic growth and a long-run increase in income levels. Ultimately, the level of
income in the economy would rise so much that the resulting increase in tax revenues would eliminate
any deficit that might result.

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514 Miller • Economics Today, Eighteenth Edition
The Congressional Research Service estimated that the economic stimulus that the Bush tax cuts had
caused had become virtually negligible by 2006. The deficits primarily caused by these cuts were very
large and had resulted in a significant growth in the deficit and resulting government borrowing. The
interest payments on this new debt offset about a quarter of the growth of revenue that occurred. In the
long run, it appears that tax cuts, especially large ones, ultimately add to the deficit.
Where on the Laffer curve did the Bush administration think the economy was located? It believed that
the economy was on the downward-sloping portion past the point at which tax revenues are maximized.
Thus, cuts in tax rates would increase government tax receipts.
Where was the economy actually located on the Laffer curve? It was on the rising portion of the Laffer
curve before tax revenues were at a maximum. Revenues fell with decreases in tax rates, and the deficit
increased.
Crowding-Out Effects during World War II
Most American history books point to World War II as a clear-cut example of beneficial expansionary fiscal
policy in action. The U.S. economy was pulled out of the Great Depression by enormous governmental
outlays for the war effort—or so the story goes. The actual situation was that the U.S. economy’s growth
rate from 1933 to 1941 was already higher than any other recorded peacetime period of the same length.
Moreover, the increase in military expenditures during World War II was not matched by a similar increase
in total output. In fact, it looks as if the crowding-out effect was relatively large, at least larger than the
history books indicate. This can be readily observed in terms of what happened to personal consumption
expenditures. They dropped by 3.5 percent in real terms from 1941 and 1942 and did not rebound to
1941 levels until after 1944. In other words, the average American saw no real increase in living
standards during the war, in spite of massive military expenditures.
Given the information presented here, what could you say about the government’s spending multiplier
during World War II? It appears to have been less than one if total output did not increase as much as
military spending. There are two possible explanations. One is that to continue spending at the same pace
even after cutting taxes, the government had to borrow to finance the resulting deficit. Consequently,
market interest rates rose, thereby causing a crowding-out effect: an offsetting fall in private spending.
Another potential explanation is that people behaved in a way predicted by the Ricardian equivalence
theorem. That is, they realized that the tax reduction today would entail a future tax increase to repay debt
that the government incurred. Thus, people saved the amount of the tax reduction instead of spending it,
so that aggregate demand did not change.
Islam and Supply-Side Economics
Supply-side economics has a long history, dating back to at least the fourteenth century. The greatest of
medieval historians, Abu Zayd Abd-ar-Rahman Ibn Khaldun (1332–1406), included in his book, The
Muqaddimah (1377), an Islamic view of supply-side economics. He pointed out that “when tax
assessments . . . upon the subjects are low, the latter have the energy and desire to do things. Cultural
enterprises grow and increase . . . . (Therefore) the number of individual imposts (taxes) and assessments
mounts.” If taxes are increased in both size and rates, “the result is that the interests of subjects in cultural
enterprises disappears, because when they compare expenditures and taxes with their income and gain and
see little profit they make, they lose all hope.” Ibn Khaldun concluded that “at the beginning of a dynasty,
taxation yields large revenue from small assessments. At the end of a dynasty, taxation yields small
revenue from large assessments.”
How do this Islamic scholar’s theories apply to the modern world? If a tax hike pushes marginal tax rates
high enough, then tax revenues may actually fall if incentives to work, save, and invest are reduced.

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Lecture Extender Examples 515
When marginal tax rates are reduced, the incentives to work, save, and invest are increased, and tax
revenues may increase.
Keynesian Fiscal Policy and the Financial Crisis of 2008
In the last quarter of 2008, a major financial crisis spread from the United States to the global economy.
The Federal Reserve created hundreds of billions of dollars and injected them into banks and the financial
system. It aggressively reduced the federal funds rate to less than 1 percent by early November. Nothing
much happened because the banks and other parts of the financial system simply held onto most of the money
that the Fed put into the economy because they perceived the risk of loans not being repaid was too great
to expand them by much. As evidence that monetary policy was ineffective, the actual federal funds rate
that banks charge each other fell as low as 0.22 percent by November, well below the official 1 percent
target rate. Politicians talked about tax cuts to stimulate the economy as well as increases in spending on
such things as infrastructure (e.g., roads and bridges). Why the revival of Keynesian fiscal policy?
Keynesian fiscal policy was to make short-run adjustments of aggregate demand to get the economy out
of a recession or depression when one occurred. If monetary policy is not working because banks hoard
reserves, then increased government spending and lower taxes will increase aggregate demand.
Chapter 14 Deficit Spending and the Public Debt
Republicans and Democrats and the Deficit
The Bush administration began with a $300 billion budget surplus in 2001. The deficit declined to
$318 billion in 2005. Then fiscal year 2008 ended with a $454 billion deficit. The reason that the
budget surplus disappeared was because of tax cuts by the Bush administration and the Republican
Congress and war spending.
Two different views of the effects of the tax cuts and increased war spending and resulting deficits
emerged from the Republicans and the Democrats. The Republicans argued that the economy was in
recession when the tax cuts were enacted and, along with the war spending, helped stimulate the
economy. The deficits were declining and would disappear in a few years as the economy continues to
grow due to the stimulus that was provided. The Democrats argued that the deficits have had no significant
impact on economic activity because the government borrowing in financial markets offset the increased
deficit from expansionary fiscal policy. As a result, there was more public spending. The public’s buying
of government bonds has offset private spending. Basically, what has happened is that government’s
share of GDP increased.
Which party is using a long-run argument concerning the effects of expansionary fiscal policy and which
is using a short-run one? The Republicans are using a short-run argument. They argue that the war
spending and tax cuts increased aggregate demand during a recession. The Democrats are using a long-run
argument, which argues that in the long run, increases in the deficit simply reallocate resources from
producing private goods to government goods though the crowding-out effect.
Would Taxing Internet Sales Wipe Out States’ Deficits?
Since 2002, state governments across the United States have faced shortfalls in their state budgets
collectively averaging about $15 billion per year until 2008, when they ballooned during the recession
and afterward. As various state governments searched for new sources of revenue to reduce their budget
deficits, applying state sales taxes to Internet purchases has emerged as one possibility. At present, a large
portion of the market transactions that take place on the Web are not subject to state sales taxes. How much
revenue would taxing Internet sales generate for state governments? Most estimates of the amount that
would be raised range somewhere between $300 million and $3.8 billion. Thus subjecting all Web

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516 Miller • Economics Today, Eighteenth Edition
purchases to state sales taxes would raise sufficient revenue to cover a tiny percentage of the states’
collective budget deficit.
How must governments of states that have constitutions that permit deficit spending always finance their
actual deficits? Because the states cannot print money to buy their bonds as the federal government can,
they must borrow from the private sector.
How must governments of states that have constitutions that do not permit deficit spending always
finance reductions in revenue that would cause a deficit? They must either raise taxes or reduce spending,
or some combination of these two options.
The Democratic Majority’s Agenda
In 2010, the Republicans regained control of the House of Representatives running on a platform of
eliminating the defict or at least drastically reducing it largely by the use of spending cuts. Two problems
face the Republicans. Entitlement spending grew to about 58 percent of the federal budget in 2010. If
interest on the national debt is added, a little more than 65 percent of the budget is committed. The
Republicans in their Pledge to America pledged not to cut Social Security, Medicare, or defense spending.
If entitlements and defense spending are not to be cut, and interest on the national debt cannot be cut, then
off-limits spending accounts for about nearly 75 percent of the budget, which is accounted for by spending
that is committed and off limits to reductions for new spending. Entitlements will increase as the Baby
Boomers retire and begin drawing Social Security and enrolling in Medicare. The Democrats have also
pledged to increase entitlements—e.g., on the Medicare prescription drug plan. The other problem is the
enormous cost of dealing with the financial crisis in 2008 and the occurring recession . Dealing with these
problems is estimated to result in about a $1 trillion increase in government spending—all on top of the
current deficit.
Why does the automatic growth in entitlement spending complicate efforts to reduce federal
government deficits? Reducing deficits requires having revenue grow faster than spending. Growing
entitlements mean that decreases in overall federal spending must come at the expense of new programs
or of existing discretionary spending. This is a difficult problem for politicians.
How does a recession complicate efforts to reduce federal government deficits? Recessions decrease
employment and income and thus tax-reduced receipts from personal income tax, payroll, and corporate
profits taxes. At the same time, federal spending on unemployment compensation and welfare programs
such as food stamps increases. Thus in a recession, deficits automatically increase as revenues decrease
and spending increases. Any new programs would be unlikely to be financed by a tax increase when the
economy is in a recession, so the only way to finance new spending programs would be to drastically
reduce spending on the 25 percent of the government programs that are not committed to in the Pledge to
America.
Deficits and the Real Tax Rate
Historically, Republicans were considered fiscal conservatives and Democrats the opposite. Republicans
have historically been associated with balanced budgets or low deficits. In modern times, that is no longer
true. Democrats argue much more against deficits than do Republicans. Indeed, under Republican
administrations, deficits have been larger than under Democratic administrations.
Some Republicans have been using the argument that real economic growth was higher during years in
which the net public debt exceeded one-third of GDP than in years when it was less than that. In other
words, real economic growth was 1 percent higher (almost 3.5 percent) in high-deficit and debt years than
it was in low-deficit years (almost 2.5 percent).

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Solution Manual for Economics Today The Macro View, 20th Edition

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