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Lipsey & Chrystal: Economics 12e

Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
Part One: Markets and Consumers

This Part goes wider than its title suggests, as it includes two preliminary chapters
introducing basic economic concepts and methodology before it gets on to the core material
on demand and supply, elasticities, and consumer choice. These opening chapters are
valuable and worth spending some time on for all students if at all possible. Chapter 1
explores the basic nature of different economic systems and introduces key concepts such
as opportunity cost and scarcity, but it also starts to open up one of the ‗big questions‘: how
much should government be involved in a modern economy? Chapter 2 establishes the
positive/normative distinction and the basic ways that economists work before going on to
data and graphs. Even students with a scientific background who are broadly familiar with
the latter need to know how economics sometimes does things differently, and how
‗scientific method‘ and the types of data available in economics differ from those in the
physical sciences. Time and effort spent here will pay off later on.

With the preliminaries of the first two chapters under their belts, students are then in a
position to embark on some serious economic analysis. The remaining three chapters in this
part of the book will enable them to do this: the introduction to the basic ideas of demand,
supply and market equilibrium in Chapter 3, plus the concepts of elasticity in Chapter 4 and
consumer equilibrium in Chapter 5, are enough to allow for some meaningful discussion of
real-life policy problems in the case studies in these chapters. This is a valuable feature, as
students all too often find ‗Principles‘ courses theoretical and dry. Demonstrating early on
that the theory can be used is the best way to counteract this impression.

Chapter 3 is clearly the crucial one in Part One, if not in the whole book. It covers demand
first, establishing why the demand curve (whether individual or market) is normally downward
sloping and setting out the difference between shifts in the curve and movements along it.
The analysis is then repeated for the supply curve, introducing the firm briefly at the
beginning, before the two sides of the market are brought together in the determination of
equilibrium market price and quantity. The diagram showing this (Figure 3.9) makes the first
of its many appearances throughout the book, some of which follow immediately in a
discussion of the effects of shifts in one or other curve. The next section of the chapter
outlines different price-setting mechanisms, such as auctions and administered pricing, and
points out that markets can be both separate and interlinked. The chapter concludes with
some case studies.

Chapter 4 sets out and discusses one of the economist‘s favourite tools, that of elasticity. As
in the previous chapter we start with demand at some length, and then the case of supply is
treated fairly quickly as the argument is basically the same. The chapter also includes a
useful discussion of the identification problem in economics, which brings a further chance to
focus on the problems of applying the theory in practice. Again the chapter is rounded off
with case studies.

Part One ends with Chapter 5 on ―Consumer choice: indifference theory‖, which introduces
the basics of consumer theory (marginal utility as well as indifference curves). A fairly
standard development of indifference curves and budget constraints leads to the consumer‘s
equilibrium. Towards the end it is shown that consumer demand curves slope down, thus
providing a clear foundation for ideas we met in Chapter 3. Some reflections on the
economics of happiness, an application of income and substitution effects to the labour
market, and an insight into experimental economics and ideas of fairness all provide further
evidence that all this theory can actually be used.

Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
These last three chapters will probably be seen by both teachers and students as the
beginning of ‗economics proper‘, but we would draw attention to the comment made below in
the overview of Chapter 2: if there is not sufficient time to cover the two preliminary chapters
in class then students should be strongly encouraged to read them for themselves. They
provide essential material for a full understanding of the main analysis.


Notes for users of the previous edition

All five chapters in this Part are very similar to their equivalents in the eleventh edition. The
major difference is that the first two chapters were not then in Part One; they formed a sort of
(unnumbered) ‗Part Zero‘ at the start of the book, preceding the main Microeconomics and
Macroeconomics divisions. Chapters 1 and 2 in this edition would be needed even for a purely
macroeconomics course (as explained in the book on page xxi).

Apart from that the only significant change to the main text is that the section on ‗government
intervention in markets‘ in Chapter 3 has been removed. Chapters 3 to 5 all have a new first
Box, which is then picked up in one of the case studies; remaining boxes are renumbered
accordingly. Some case studies have been revised and others replaced by new ones. The end-
of-chapter questions are unchanged in content; there are some very minor amendments to
wording, and in some cases lettering of sub-sections has been replaced by bulleting.

One other change that applies throughout the book is worth noting here. Equations are now
numbered to include the chapter number—for example, the first equation in Chapter 4 is now
(4.1) instead of just (1)—and they are written on one line more often than in the previous
edition.


Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
Chapter 1: Economic Issues and Concepts

This chapter provides an introduction to some important underlying themes in economics. It
opens by noting that no-one sat down and planned the modern economy; it just evolved.
The main tasks in the book are to study how such a hugely complex system operates, why it
sometimes fails, and how its performance can be improved. Very brief definitions of
microeconomics and macroeconomics are given at this point before a quick look ahead to
the rest of the chapter.

This has four sections. The first starts off from things we take for granted, but should not—the
easy availability of a pint of milk, for example, or the production of everyday goods like
toasters (a product whose unexpected complexity is explored in Box 1.1) at low prices. What
lies behind these marvels? The main text explains how market economies organize
themselves, quoting Adam Smith in support, while Box 1.2 examines the reasons for the
failure of central planning as a means of organizing economic activity. This box is a real help in
understanding some of the main advantages of the market system.

The next section stresses the notions of scarcity, choice, and opportunity cost. These
concepts will come up many times throughout the course of the book and are, indeed, the
basic and unifying notions of the subject. The production possibility boundary is then
introduced, and is shown to embody the three concepts of scarcity, choice, and opportunity
cost. Its nature as a frontier between the attainable and the unattainable is worth stressing,
as is the fact that what is attainable is itself subject to change. There is a detailed discussion
of why the production possibility boundary is usually (but not always) drawn convex to the
origin, reflecting increasing opportunity cost.

Recognizing that choices have to be made, the third section explores the questions of who
makes these choices and how choices are made. The answer to the first question is: anyone
who is ‗economically active‘. Decisions are at once maximizing and made at the margin—both
key concepts. The discussion of production choices leads to a first treatment of some
characteristics of production such as specialization, division of labour, and globalization. Box
1.4 on absolute and comparative advantage introduces one of the more important
contributions made by economics, the principle of comparative advantage, and thus illustrates
the gains from specialization and trade. Students do not have to wait for Chapter 27 on
international trade in order to get this important message. Trade is a necessary consequence
of specialization, and the use of money facilitates trade.

The last section of the chapter compares economic systems. Students will read in almost
every chapter of this book about a market economy. Contrasting it with planned and
traditional economies is a good way to gain some insight into the concept at the outset. The
authors emphasize that actual economies are rarely, if ever, well represented by the
extremes; instead, actual economies are mixed economies, with varying degrees of
government ownership and planning. Governments themselves have both micro and macro
roles. Whereas previously these had been somewhat separate, the text suggests that the
financial crisis of 2007/08 and the ensuing world-wide recession have brought them
together; Box 1.5 develops this idea.


Notes for users of the previous edition

This chapter is broadly the same as its predecessor in the eleventh edition, but there are
some significant changes:

Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
 Some material on the opening page has been rearranged; in particular the ‗pint of milk‘
example has moved from the introduction into the first section.
 The mention of the meanings of microeconomics and macroeconomics in the
introduction is new.
 Box 1.1 on the complexity of the production process for a toaster is new (so remaining
boxes are renumbered).
 The eye-catching statement on page 3 of the eleventh edition that ―Adam Smith was right
and Karl Marx was wrong‖ has been deleted.
 There is a subtle shift of responsibility in the text a few lines later. Where the previous
edition said, referring to Marx, ―Where he was wrong, however, was in believing …‖, the
new book (page 7) says ―Where the Marxists were wrong, however, was in believing …
(emphasis added).
 At the start of the old third section, the sub-heading ―The flow of income and
expenditure‖ has been replaced with ―Spending choices‖. The opening discussion of the
circular flow of income and variations in the distribution of income, plus the
accompanying Figure 1.3, have been deleted; they are replaced by the first two
paragraphs under ―Spending choices‖ on page 12 of the new edition.
 The sub-section on ―Consumer sovereignty‖ at the end of this section is new.
 The fourth section has a new title—―Government and the market economy‖ instead of ―Is
there a practical alternative to the market economy?‖—but most of the content has been
carried over unchanged. The exception is that the final two short paragraphs in the old
book (pages 13–14) have been replaced by the new final subsection entitled ―Macro and
micro roles of government‖ and Box 1.5, which look at how the recent financial crisis led
to a new role for government.

The end-of-chapter questions are unchanged.


Answers to end-of-chapter questions

Questions 1 to 4 are designed to make new students of economics think more like an
economist about everyday activities and the choices they themselves make as economic
agents. Different students‘ answers to Questions 2 to 4 are likely to vary considerably.


5 Opportunity cost is the measurement of cost in terms of the alternatives foregone. Note
that the student should appreciate that while an individual may have many possible
choices, the opportunity cost of a particular decision is that of the next best choice only.


6 This is a good question to provoke a debate about ‗progress‘. The differences between
traditional, command, and market economies are outlined on pages 15–16. The use of
‗superseded‘ in the question is a little misleading since, as the text points out, modern
economies are mixed economies and contain elements of all three types of economy.
However, traditional and command economies do not provide the same element of
choice for individuals as a mixed economy and, in the long run, such economies fail to
deliver rising living standards because they use resources less efficiently.


7 Division of labour is only possible if people specialize in doing particular forms of work,
rather than trying to be self-sufficient. However, if not self-sufficient, people need to
exchange goods and services and this is most efficiently done in a market where
Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
information is available about choices and comparisons can be made. The use of money
as a medium of exchange makes markets work much more easily—money is a lubricant.


8 As a minimum, government has an essential role in a market economy in providing a
legal framework in which property rights are acknowledged and respected. Governments
also need to ensure that money has a stable value, and may be able to intervene to
correct some forms of market failure.


9 This is another question which could provoke a lively debate. Some productive resources
are more scarce than others but economic history seems to show that over time
improvements in technology help find ways around problems of scarcity. However many
shortages are caused by failures of distribution, or by war. Any sceptic would feel that
such causes of scarcity are likely to continue into the foreseeable future.


Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
Chapter 2: How Economists Work

Chapter 2 has four sections. The first makes clear the crucial distinction between positive and
normative questions, the second examines economics as a social science, and the last two
deal with data and graphs.

The chapter provides a longer introduction to the methodological issues of economics than is
usually included in introductory texts. Most students believe that the scientific method is limited
to the natural sciences but, to appreciate economics, they must understand that its theories too
are open to empirical testing and that these theories continually change as a result of what the
empirical evidence shows.

Students typically do not learn enough about the connection between theory and evidence, and
how both are central to understanding economic phenomena. It is difficult to call economics an
entirely ‗theory-driven‘ or ‗data-driven‘ discipline. Without the theory and models, we do not
know what to look for in the data; but without experiencing the world around us we cannot build
models of human behaviour and interaction through markets. The scientific approach in
economics, as in the ‗hard‘ sciences, thus involves a close relationship between theory and
evidence.

When we say that economics can be scientific we do not mean that it can crank out exact
answers that are beyond dispute; we mean, rather, that it deals with questions that can be
related to empirical evidence and that the balance of probability can be established among
competing answers to at least some questions. Students need to be able to see how evidence
can be used to confront assertions about the world and to recognize how assertions can be
made sufficiently specific to be confronted with evidence.

Although aware of the ‗post-Popperian‘ methodology, the authors‘ position agrees with that
marked out by Mark Blaug in The Methodology of Economics (Cambridge University Press,
2nd edition, 1993): economics progresses (or not) according to its ability to explain,
understand, and offer conditional predictions about what we see in the real world around us.

Turning now to the last two sections of the chapter, these contain essential material on index
numbers, graphing economic data, and graphing economic theories (note the counterpoint).
Some students will already feel at home with some or all of this but they should be encouraged
to review these pages nevertheless. The less confident should study them in detail.

Some instructors feel their time is so limited that they cannot spend class time on Chapter 2;
even so, students‘ attention should be called to the questions addressed in the chapter.
Experience shows that many students do benefit from some discussion of the scientific method
and from the insight that the social sciences generally are not all that different from the ‗hard‘
sciences, at least in their basic approaches. Students should seek to understand the scientific
approach to human behaviour and to clarify the aspects of it that worry them, returning to any
unsettled issues after they have seen economics ‗in action‘.


Notes for users of the previous edition

There are no significant changes from the eleventh edition. There are a few small additions
and changes to the text, and dates in some hypothetical examples have been altered to
current ones, but the only real change is the updating of the unemployment data in Figures
2.1 and 2.2 and the accompanying text on page 28. Apart from this, all figures, boxes and
end-of chapter questions are essentially the same.
Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.


Answers to end-of-chapter questions

1 (a) Positive: though not necessarily true the proposition may be tested for accuracy using
a generally acceptable definition of good health.

(b) Positive: whether or not it is true may be tested by appeal to the facts.

(c) Normative: this expresses a value judgement about what is desirable.

(d) The first part of this statement is positive, in that its truth may be established by an
appeal to relevant facts, but the second part of the statement is normative.

Beginning students often confuse ‗vague‘ with ‗normative‘. It is just as easy to be vague
on positive issues as on normative issues, and some vague statements may have to be
put down as unclassifiable, but that is only because we do not know what is being said.
Even in the four statements in this question there is scope for the argumentative to
consider what the words mean exactly.


2 Require students to use graph paper for this exercise and to draw each graph as
accurately as possible.


3
1987 1998 1999 2000 2001 2002
100 160.6 164.3 170.3 171.3 175.1
100 102.3 106.0 106.7 109

The numbers in italics above are for the last part of the question.


4 After five scores of 100 runs the total runs are 500 and average runs per innings are 100.
After three poor innings of 50, 20, and no runsthese are the batsman‘s marginal
scoreshis total runs are 570 and his average score is 71.25 runs per innings. Following
marginal scores of 120, 140, and 160 runs his total run score becomes 990 and his
average is 90 runs per innings. The general principle is that when the marginal score is
above the average score then the average rises, and when the marginal score is below
the average, the average falls.


5 A scientific approach to economics, or physics, or medicine, depends on being able to
distinguish between the facts and rational argument on the one hand and expressions of
opinion on the other.


6 Understanding ‗how the economy works‘ involves having both a broad overview and a
grasp of how individual people or enterprises behave. Both can be modelled and the
predictions of any model tested to see whether the model is a reliable guide to an aspect
of the economy. Models assist us by abstracting from a confusing mass of information a
relationship, or set of relationships, between potentially interesting features of the
economy. Sometimes a model is couched in very general termsthink, for example, of
Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
the circular flowand in such cases the very simplicity of the model helps us understand
an otherwise excessively complex whole.

Many simple models have wide applicability. Currently in the UK the level of graduate
debt is rising quite rapidly, which implies that the costs of higher education borne by the
student are growing. How does this affect demand? At the same time the government has
encouraged a significant expansion in the numbers of students in higher education so the
supply of graduates has increased. What does this imply for graduate salaries? If the
returns to higher education go on falling as the price of higher education rises, will people
want more of it or less?


7 Though the behaviour of any one individual may seem unpredictable to a stranger, the
greater the number of people being studied the more predictable the majority behaviour is
likely to be. In other words, we can generalize with greater safety. Much economic
analysis involves looking at change at the margin, where the interesting things happen, so
even if the majority of people do not immediately change their behaviour in response to a
changed incentive, some will and their behaviour is significant.


8 This is a good question for students new to economics who are often offended by what
they perceive as gross oversimplification. An economic model has to start with simplifying
assumptions and its predictions will only be as good as the assumptions are explicit and
appropriate. This does not mean that its predictions are useless in all situations.

Chapter 3: Demand and Supply

This chapter is a fundamental one. It introduces the basic demand and supply curves, and
the concept of market equilibrium. There are four main sections.

The first concentrates on demand. It starts with the motives of individuals and the nature of
demand, followed by a list of the factors determining it and the introduction of the concept of
the demand function. It then goes on to explain why the demand curve is downward
sloping, illustrating the analysis with a simple numerical example. The market demand curve
is derived by aggregating the demand curves of two individuals. There is a short section on
the effects of income distribution. Factors leading to a shift in the curve are then discussed,
introducing the terms substitute and complement, together with the distinction between
shifts in the curve and movements along it.

The second section is a broadly parallel treatment of supply. Firms are introduced along with
the nature of supply. The factors determining supply, why the curve slopes up, shifts in the
curve, and the difference between shifts of and movements along the curve, are all covered
much as they were for demand.

The concept of a market is introduced in the third section, and the two parts of the theory so
far are then brought together in the determination of market price. The analysis here is
primarily graphical. There is then a discussion of what happens if the market does not clear
and of the ‗predictions of supply and demand analysis‘—mainly the effects of shifts in either
curve. Finally the idea of inflation is introduced briefly in Box 3.4, via its effects on relative
prices.

The fourth section first looks at different types of prices—administered and auction prices in
particular—and argues that even the former do still behave according to the ‗predictions‘ set
Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
out earlier in the chapter. It then explains why individual markets can be both separate and
interlinked.

This is followed by two case studies. The first, which picks up on a Financial Times article
quoted in Box 3.1, looks at the effects of drought on the market for tea in 2008 and 2009; the
second considers the market for tin over the period 1994-2009 and how demand and supply
can explain the sharp spike in prices in 2008. The chapter ends with a brief conclusion,
which stresses how far the tools developed in it can take us. This underlines the caveat
below.



Notes for users of the previous edition

The bulk of this chapter is largely unchanged from Chapter 3 in the eleventh edition, with
only small amounts of minor re-writing and the odd bit of updating (although note that the re-
writing includes a change in the chapter title, which was previously ―Demand, Supply and
Price‖). The main difference is that that edition had a fifth section on ―Government
intervention in markets‖; this has been deleted.

There are two substantive additions to the main text: Box 3.1 on the effects of drought on tea
prices is new (which means that the previous Boxes 3.1-3.4 are now Boxes 3.2-3.5), and
there is a useful new ‗Summary‘ at the end of the discussion of administered pricing which
provides some helpful intuition on the different types of pricing.

Both case studies are new, and replace the three that were used in the eleventh edition (on
the market for steel in the period 1970–2004, the impact of the Channel Tunnel, and the
problems caused by the intervention prices in the EU‘s Common Agricultural Policy).

The end-of-chapter questions are the same as before, except that the three sections within
Question 7 are no longer labelled (a), (b) and (c).

Answers to end-of-chapter questions

1 (a) Setting supply equal to demand: £100 – 2q = 3q, so q* = 20 and p* = £60.

(b) Note supply is fixed here (the supply curve is vertical). Equilibrium p* is therefore
£40.

(c) Demand is infinitely elastic this time (the demand curve is horizontal). q* = 16.


2 (a) Supply curve shifts left (and is likely to be fairly steep); price rises, quantity falls.

Teaching Note It is all too easy when teaching the material of this chapter to assume that,
because it is so basic, it can be covered very quickly. Experience suggests that this is not
the case and that a good deal of repetition is important. The difference between (a) shifts in
and (b) movements along demand and supply curves is worth going over several times, and
the basic market equilibrium in Figure 3.9 is worth developing on the board or overhead
projector. The meaning of ceteris paribus is also worth spending some time on, using
different examples.
Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
(b) Demand curve shifts right; price rises, quantity rises. Note that in the short run the
supply of hotel rooms is more or less fixed, so the supply curve is near-vertical and
almost all the effect will be on price. In the longer run the supply curve may shift out
(to the right) too, producing a rise in quantity and a drop in price.

(c) The supply curve shifts to the right, increasing output and reducing price.

(d) It is worth considering the North American and other markets separately here, as a
good example of the interlinking of markets discussed in the final section of the
chapter. Demand has increased in the American market, raising price and output
there. This in turn will shift the supply curve elsewhere to the left, raising price and
cutting output there. World oil output is likely to rise, as the supply of oil is not fixed in
the short run, but not enough to keep prices at their original level.

(e) The obvious effect will be to shift the supply curve sharply to the left, raising price and
cutting output. However there is likely to be an effect on demand as well, especially if
there is perceived to be a risk to human health from beef consumption, so the
demand curve will also shift left, magnifying the output fall but mitigating the price
rise. Finally, as shown in the BSE crisis in the UK, export demand is likely to slump,
which will also push the demand curve to the left.


3 Obviously different students will produce different answers here. The majority of markets
listed are likely to be ones where prices are mainly administered, as few students will be
involved in the housing or car markets. However they may use street markets where there
is an element of auction pricing for some goods, especially at the end of the day or week.
They may also have particular interests in goods where demand changes can be frequent
and marked—clothes, CDs, mobile phones, computers and their accessories (including
computer games), night clubs and concerts, for example—and in these markets there is
likely to be at least some ‗mixed pricing‘. Excess demand may lead to rationing (queuing,
for tickets or entry to popular clubs, for example) or black markets; excess supply to one-
off clearance sales or deals which do not technically change the headline price (―buy one,
get one free‖, or extra points on a card scheme, for example).


4 This is revision of the material in the text, on pages 38 (demand factors), 44-45 (supply
factors) and 47–50 (equilibrium) in particular.


5 Again, a close reflection of text material, this time pages 51–53 in the final part of the
chapter.


6 The main condition is presumably that we need a pair of demand and supply curves with
one clear intersection point. They do not necessarily have to slope in opposite directions.
However if they do not it raises the issue of stability of the equilibrium. This is covered in a
paragraph on pages 48–49, but the basic requirement is that the demand curve be
steeper (in the sense of a more negative slope) than the supply curve. Thus a downward-
sloping supply curve could still produce a stable equilibrium as long as it is flatter than the
demand curve. However if the supply curve slopes down more steeply than the demand
curve then the equilibrium will not be stable. Also if both curves were wholly inelastic
(vertical) we have problems, as there will be no clear finite positive price.

Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.

7 A rise in consumer income will shift the demand curve to the right, raising market price
and output (how much of each will depend on the shape of the supply curve).

A fall in production costs will shift the supply curve to the right, cutting price and raising
output (again, how much of each depends on the shape of the demand curve)

Fixed-line calls are a substitute for mobile calls, so a fall in their price will shift the demand
curve for mobile phones to the left. This shift may not be very large, as the two goods are
not perfect substitutes, and consumers may still value the ownership of a mobile phone
(although they may use it less).

Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
Chapter 4: Elasticity of Demand and Supply

This chapter has a relatively narrow focus on elasticity. It starts with a useful brief illustration
of why the concept is significant, looking at how the effects of a government tax on petrol are
affected by the slope of the demand curve, and Box 4.1 introduces some real-life price
changes in the coffee and sugar markets which elasticity will help to explain. Thereafter the
chapter has four main sections.

The first concerns the elasticity of demand. The section starts by defining the term and
giving examples of how to calculate it. It then discusses the interpretation of the term,
introducing the ideas of elastic, unit elastic and inelastic demands and the link with total
spending. This is followed by a closer look at the finer points of measuring elasticity,
including arc and point measures, and the standard result that elasticity varies along a
linear demand curve. The coverage of own-price elasticity ends with a discussion of the
factors determining its numerical value, including the time period considered and how widely
or narrowly the product is defined. The section ends with an analysis of the cross-price and
income elasticities of demand. Box 4.2 on page 62 summarizes the terminology for own-
price, cross-price and income elasticities in a simple and clear fashion.

The second section is on supply elasticity. It is brief, mainly because the concept is just an
adaptation of the elasticity of demand covered in the previous section. It does however draw
out the point that any linear supply curve passing through the origin has an elasticity of unity
throughout its length (see Figure 4.10).

The third section concerns measuring demand and supply in practice. Note that the
discussion here covers more than just elasticities, including the identification problem for
example. Table 4.2 includes estimated price and income elasticities for selected foods in the
UK over recent years. Multiple regression analysis is mentioned in passing in this section,
but it is not developed at all, and it can be skipped past easily enough if students are not
familiar with the term.

The final main section consists of three case studies. The first examines the world coffee
market, where historically low prices have been caused by supply growing faster than
demand over the last decade. The second picks up on the sugar and coffee markets story
introduced in Box 4.1 and draws out some of the differences between the two crops: weather
affects sugar production less; sugar has an alternative non-food use as a raw material for
ethanol, so there is a link between sugar prices and oil prices; and sugar has been subject to
protection by both the US and the EU. The third case study is the 1993 price war among UK
broadsheet newspapers and what has happened since. The analysis here yields estimates
of the elasticities of demand for the different newspapers involved, and permits some basic
supply and demand analysis of the initial price cuts made by The Times.


Notes for users of the previous edition

The first three sections are very similar to Chapter 4 in the eleventh edition; there is only very
minor re-writing. The fourth section—the case studies—has been changed somewhat: the
coffee market case is now based on a longer data period (both before and after the previous
one); the UK museums case has been replaced by the (mainly) sugar markets study
mentioned above; and the ‗newspaper war‘ study is as before.

There are a few substantive changes to the main text. Box 4.1 on the coffee and sugar
markets is new (which means that the previous Boxes 4.1-4.4 now drop back to become
Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
Boxes 4.2-4.5), and in Box 4.5 (―Elasticity matters‖—formerly Box 4.4) the USSR gold
example has been dropped and there is a new example concerning water meters and the
(likely lack of) effectiveness of price rises in cutting consumption. The section on long- and
short-run own-price elasticities has been augmented by a discussion pointing out that long-
run values do not always exceed their short-run counterparts; the authors clearly feel that the
examples, which go the other way, may have oversold their case. A similar point is now
made for income elasticities. Finally, the paragraph headed ―Other evidence‖ towards the
end of the section on measuring elasticities is new.

The end-of-chapter questions are the same as before, except that the five explanations
within Question 3 are no longer labelled (a)–(e) but are now bulleted instead.


Answers to end-of-chapter questions

1 Rewriting the equation as Q = 20 – 0.2P and using calculus we find dQ/dP = –0.2. The
formula for elasticity is (P/Q).(dQ/dP), so the values are as follows:
At P = 90 and Q = 2 elasticity = (90/2).(–0.2) = –9.0 (highly elastic).
At P = 50 and Q = 10 elasticity = (50/10).(–0.2) = –1.0 (this is the half-way point on
the demand curve).
At P = 5 and Q = 19 elasticity = (5/19).(–0.2) = –0.053 (highly inelastic).


2 Rewriting the equation as Q = (1/3)P – (10/3) and using calculus we find dQ/dP = (1/3).
The formula for elasticity is (P/Q).(dQ/dP), so the values are as follows:
At P = 25 and Q = 5 elasticity = (25/5).(1/3) = 5/3 ≈ 1.667 (fairly elastic).
At P = 40 and Q = 10 elasticity = (40/10).(1/3) = 4/3 ≈ 1.333 (elastic).
At P = 70 and Q = 20 elasticity = (70/20).(1/3) = 3.5/3 ≈ 1.167 (slightly elastic).

Note that the supply elasticity → 1 as Q → ∞.


3 The price and quantity of potatoes have both risen. In terms of Figure 4.11 we cannot
therefore be in the left hand section—so a supply shift alone cannot be responsible for the
observation (assuming potatoes are not a Giffen good).

1st explanation Consistent. The demand curve for potatoes will shift to the right if the
price of substitute rises, so we have traced out the supply curve as in Figure 4.11(ii).

2nd explanation Inconsistent. The rise in price of a complement will shift the demand
curve for potatoes to the left, which is not consistent with both price and quantity rising.

3rd explanation Inconsistent. Output has risen, which would not happen with bad weather
(unless we allow for potatoes being withdrawn from storage to meet a shortage due to a
poor harvest). Bad weather generates a supply curve shift, which as noted above cannot
be the case with the present observation.

4th explanation Inconsistent. If potatoes are inferior the change in incomes will shift the
demand curve to the left (Chapter 3, page 42), so price and output should both fall.

5th explanation Consistent. Like (a) this will shift the demand curve for potatoes to the
right.

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© Oxford University Press, 2011. All rights reserved.

4 The purpose of the question is to focus on the difference between the factors affecting price
elasticity and those affecting income elasticity, as discussed in the text. The primary
influence on price elasticity is the closeness of substitutes. The primary influence on income
elasticity is whether the commodity is regarded as a necessity or a luxury at current levels of
income. Note the different breadths of the categories in the examples below (for example,
large cars in general versus Rolls Royces in particular).

(a) Holidays in Mustique, a particular model of Rolls Royce, one particular kind of seafood
such as crab or scallops; the goods have close substitutes and are not basic
commodities.

(b) Front-row seats at the opera, large cars in general; goods and services with no close
substitutes, and which are associated with a certain lifestyle.

(c) Bread, potatoes, socks, salt, boxes of matches. These are basic items of food,
clothing and so on, and often make up a very small proportion of an individual‘s
spending.

(d) Heinz baked beans, Cadbury‘s chocolate, one kind of root vegetable. These are
narrowly defined goods with close substitutes, and are basic commodities.


5 The standard definition is the one given in Equation (4.1) on page 60: η = %∆Q/%∆P, to
put it in symbols. The concept should interest those setting prices in business because it
tells them what effect a price change will have on their total revenue. See the discussion
of ―Elasticity and total spending‖ on pages 61–62.


6 Because consumers may take some time to react to a change in price. Reasons for this
would include: they do not find out immediately about the change; they are addicted to the
good and tastes only change slowly; or they are locked in to a particular consumption
pattern in the short run. For example, a motorist may reduce their petrol consumption a bit
in the short run if the price rises, but that is likely to be all they (can) do. In the longer run
they may change to a smaller car, or one that runs on diesel or LPG, or not replace their
car at all when it wears out. See pages 66–67 in the main text.

A minor counter-example is the way that when petrol duty has increased significantly in
the Budget people start to walk to the shops and other nearby destinations—but this often
only lasts until the next wet day!


7 This is clearly set out in the text on pages 65–67 (for demand) and page 70 (for supply).


8 Another revision question, based on page 71 and Figure 4.11.


9 Income elasticity is the responsiveness of quantity demanded to the consumer‘s income;
see page 67. It will be low for food in rich countries because most people have enough to
eat and do not need to spend more as their income rises. Note that this is for food as a
whole, and would not apply to individual foodstuffs—think of champagne or caviar, for
example. Other examples of goods and services with high income elasticities in rich
Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
countries would be expensive sports cars, opera tickets, luxury cruises, long-haul tourism,
massages at health farms, top end hi-fi equipment, and so on (see also the answers to
Questions 4(a) and (b) above).

These goods and services are unlikely to be consumed at all in poor countries, so their
income elasticity there will be zero (see Figure 4.9). High income elasticities would be
found for items further down the scale: basic cars, foreign holidays of any sort, imported
foodstuffs, radios, air conditioning in hot countries, etc.

Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
Chapter 5: Consumer Choice: Indifference Theory

This chapter provides an introduction to consumer theory, including both ideas of utility and
the use of indifference curves, and taking the latter far enough to be able to end the chapter
with case studies based on the happiness literature, ―income and substitution effects in
practice‖, and experimental economics. There are four main sections before we get there,
however.

The first is entitled ―Early insights‖ (although Box 5.1 introduces quite recent insights on
happiness and utility), and introduces the concepts of total utility and marginal utility,
making clear the importance of the marginal revolution in switching attention to the latter. It
uses the classical case of water as an example to illustrate the law of diminishing
marginal utility. It then shows how a consumer allocates her income to maximize her utility,
initially for a simple one-product equilibrium and then in a more realistic multi-product case.
This produces the basic equilibrium condition MU
X
/P
X
= MU
Y
/P
Y
, the ‗fundamental equation
of utility theory‘ (page 84). The equation is then analysed in the alternative form MU
X
/MU
Y
=
P
X
/P
Y
, to bring out the way the consumer adjusts her behaviour to make the equation hold
true. This in turn is used to derive the prediction that demand curves slope downwards. The
importance of marginal values is again stressed, with the paradox of value discussed in Box
5.2. Consumers’ surplus is outlined in Box 5.3.

The second section discusses ―Consumer optimization without measurable utility‖. It follows
the normal pattern of developing the two sides—the indifference map and the budget
constraint—separately and then bringing them together to show the consumer‘s equilibrium
at a tangency point between the two. Box 5.4 explores the range of shapes that can be
taken by indifference curves. The analysis throughout is mainly diagrammatic.

The next part of the chapter goes on to analyse how the consumer responds to changes in
income or relative prices, showing the income- and price-consumption lines. This framework
is then used to explore the distinction between real and money income that was first introduced
briefly in Box 3.4. The third section of the chapter shows the derivation of the demand curve
from the price-consumption line, and then introduces income and substitution effects. Giffen
and non-Giffen goods are explained.

The chapter ends with the case studies mentioned above. The first (and quite lengthy) one
picks up on the happiness theme from Box 5.1. It introduces the importance individuals give to
their relative positions and explores why richer countries are not always happier countries, and
goes to some lengths to argue that ‗happiness research‘ does not invalidate the utility-based
analysis developed earlier in the chapter. The second case study uses income and substitution
effects to analyse labour supply decisions, and the third is mainly an extract from a journal
article entitled ―The economics of fair play‖, which is used to argue that individuals do not
always act as the selfish homo economicus implies.


Notes for users of the previous edition

With the exception of Box 5.1 and the related case Study 1, which are both new, this chapter
is virtually identical to its predecessor in the eleventh edition (that chapter was however a
major revision from the tenth edition). The new Box 5.1 means the other five boxes in the
chapter are renumbered (5.1 becomes 5.2, and so on).

The end-of-chapter questions are the same as before, except that the five statements within
Question 4 are no longer labelled (a)–(e) but are now bulleted instead.
Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.


Answers to end-of-chapter questions

1 The two extreme solutions are to spend all her income on one good: either 10 meals or 20
concerts. Intermediate combinations would be (M=9,C=2), (M=8,C=4), (M=7,C=6), etc,
trading one meal for two concerts as you go. A graph of the possibilities would be a
downward-sloping straight line between the two points (M=10,C=0) and (M=0,C=20).


2 This will double the number of meals in each combination above, and also allow for some
intermediate combinations that were not sensible before, such as spending £150 on meals
and £50 on concerts. The combinations will now run (M=20,C=0), (M=19,C=1), (M=18,C=2),
etc. Graphically the line now goes from (M=20,C=0) to (M=0,C=20); that is, the same point
on the C axis but twice as far out on the M axis. This is similar to the move from ab to ac in
Figure 5.8.


3 Five meals at £20 and ten concerts at £10 just absorbs the income of £200. If the price of
meals falls to £10 the total cost falls to £150. Thus we could take £50 away from the
consumer and leave them just able to buy this bundle of goods (in technical terms, this is
the compensating variation of the price change). It is unlikely however that they would still
consume the bundle (M=5,C=10) in this situation, as the relative prices of the two goods
have changed. We have removed the income effect of the price fall but there will still be a
substitution effect. It may help to look at Box 5.6 here; we start at A, the price change takes
us to B, the removal of £50 income takes us to the broken line through A, but the consumer
now prefers D.


4 1st statement False—the substitution effect is always negative (you will always shift away
from X if its price rises).

2nd statement True—see Figure 5.10 for example.

3rd statement True—more or less a definition of an inferior good.

4th statement True—this is the opposite of (a) above, which was false.

5th statement False—for her to buy more requires X to be a Giffen good, which is a
stronger condition that just being inferior. Inferiority means the income effect will make her
buy more, but the substitution effect is still likely to outweigh this.


5 This is a revision question, based on the text on pages 97–99 and Figure 5.10.


6 This is well explained in Figure 5.11 and in the text on pages 97–98.


7 The quote is, perhaps not surprisingly, rather an extreme view. A simple riposte would be
that indifference curve analysis can also tell us why, and when, demand curves have a
negative slope. It is also the foundation for further work, including of course the consumer
Lipsey & Chrystal: Economics 12e
Instructor's Manual
© Oxford University Press, 2011. All rights reserved.
equilibrium set out in this chapter. It is needed too for the distinction between income and
substitution effects, although students may not find this justification particularly appealing!


8 The question is a little unclear on whether the good being used as wages—call it Good X—
can be traded at all. If not, the workers are stuck with a corner solution on the X-axis in an
(all other goods, X) or (£,X) diagram. They will not be very happy, unless they have rather
unusual indifference curves. (An extension of the question would be to ask when the
workers would have chosen such a corner solution of their own free will, the answer being
found in part (vi) of Box 5.4.)

If the good can be traded at no cost then the workers should be indifferent—but there are
always likely to be some costs involved in the conversion.

All of this could lead on to a discussion of the economic arguments on why in general
people prefer income in cash rather than kind, which is a standard topic in intermediate
microeconomics texts (and crops up in Chapter 14, Question 4 of the present text).