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To minimize the

To minimize the deadweight loss, a tax should; a. Be broad-based. A broad-based tax has little effect on relative prices, and thus has little effect on the decisions made in the private market. Example 11: If a 1% sales tax is imposed on all consumer goods and services, consumption will fall. But since the relative prices of all goods and services will be unchanged, the mix of goods and services consumed will be unchanged. The market equilibrium, after the tax, will still reflect private decisions about costs and benefits. If a narrowly-based tax is imposed (e.g. a 50% sales tax on dairy products), the decisions in the private market will be distorted (people buy fewer dairy products, not based on costs and benefits, but based on the tax). For an extreme example; a 5000% tax is imposed on ice cream. At this tax rate, no ice cream is produced or consumed. Many mutually beneficial transactions are eliminated. And the government collects zero tax revenue from the tax. The only effect of the tax is to impose excess burden. b. Have low rates. Low tax rates help to minimize the effect on the decisions made in the private market. Example 12A: A tax rate of 1% on income would have little effect on the production decisions of households. Probably no one will withdraw from the labor market due to the disincentive caused by a 1% income tax. A tax rate of 50% on income would have a larger effect on the production decisions of households. Many persons may withdraw from the labor market due to the disincentive caused by a 50% income tax or may be less motivated to improve the productivity of their labor. What if a 100% tax is imposed on income? At this rate, no income will be produced. The economy loses out on trillions of dollars worth of production. And the government collects zero tax revenue from the tax. The only effect of the tax is to impose excess burden. Example 12B: We will see in Chapter 17 that one of the factors that determines the size of the deadweight loss of a tax is the tax rate. A lower tax rate will mean a smaller deadweight loss. A higher tax rate will mean a larger deadweight loss. Refer to Examples 15 and 17 in Chapter 17 to see how an increase in the tax rate increases the deadweight loss of a tax. c. Be imposed on inelastic goods. The price elasticity of demand and supply for a good determines how responsive buyers and sellers are to a change in the price of the good. For inelastic goods, buyers and sellers are not very responsive to a change in price. Thus a tax imposed on an inelastic good will have a relatively small effect on the market outcome. Example 13: We will see in Chapter 17 that one of the factors that determines the size of the deadweight loss of a tax is the price elasticity of demand and supply. The more elastic the demand curve, the greater the deadweight loss of the tax. The less elastic the demand curve, the smaller the deadweight loss of the tax. Likewise, the more elastic the supply curve, the greater the deadweight loss of the tax. And the less elastic the supply curve, the smaller the deadweight loss of the tax. Refer to Examples 15 and 16 in Chapter 17 to see how an increase in the price elasticity of demand for a good increases the deadweight loss of a tax imposed on the good. Is the Federal Personal Income Tax a Good Tax? The largest source of tax revenue for the federal government is the federal personal income tax. Having just considered the characteristics of a good tax, we can evaluate whether the personal income tax is a good (economically efficient) tax. Unfortunately, it is not. The federal personal income tax imposes a large excess burden. The personal income tax is extremely complicated. The federal income tax code contains about 3.8 million words. (That’s almost 5 times as many words as are in the Bible.) This complexity causes the collection cost of the tax to be high. In 2014, the IRS had about 84,000 full-time employees and a budget of over $11 billion. FOR REVIEW ONLY - NOT FOR DISTRIBUTION Taxes, Deficits, and the National Debt 13 - 6

The complexity of the tax law also causes the compliance cost of the tax to be high. According to the IRS, taxpayers spend over 6 billion hours annually keeping records and filling out forms required to comply with the tax law. They also pay billions of dollars for professional tax help. The Tax Foundation estimates the compliance cost of the federal personal income tax and the corporate income tax at more than twenty percent of the tax revenue collected. The federal personal income tax also imposes a large deadweight loss. The tax appears to be broad-based, with its general rules that all income is subject to tax and that no expense is deductible. However, the tax base is made narrower by the presence of numerous loopholes. Loopholes – exclusions and exemptions from income, deductible expenses, and tax credits. The presence of loopholes distorts the decisions made in private markets. Taxpayers will alter their behavior to generate income and expenses that receive favorable tax treatment and to avoid income and expenses that receive unfavorable tax treatment. Many of the loopholes are large. The table in Example 14 below lists some of the larger loopholes for the tax year 2015, and the estimated amount of taxes avoided by each loophole. The information is from the Office of Management and Budget. Example 14: Loophole Exclusion of employer provided medical insurance Exclusion of pension contributions and earnings Deduction of state and local income and property taxes Deduction of home mortgage interest Deduction of charitable contributions Capital gains exclusion on home sales Exclusion of interest on municipal bonds Taxes Avoided $207 billion 148 billion 83 billion 74 billion 57 billion 57 billion 35 billion Collectively, the loopholes reduce the tax base (personal income) by around 50 percent. This means that higher tax rates must be imposed to collect the same amount of tax revenue that could be collected with lower tax rates and a broader tax base. The loopholes are also a big factor in making the tax complicated. What Would Make the Federal Personal Income Tax a Better Tax? A good (economically efficient) tax is one which imposes as little excess burden as possible. The federal personal income tax imposes a large excess burden. To make the federal personal income tax a better tax, the excess burden it imposes would need to be reduced. How can that be done? Make the federal personal income tax simpler. Eliminate most (or all) of the loopholes. This would reduce the collection cost and the compliance cost dramatically. IRS agents and tax accountants could be retrained to do something productive. Taxpayers could spend minutes on their tax returns instead of hours. Eliminating the loopholes would stop the distortion of private market decisions currently caused by the loopholes. Eliminating the loopholes would also broaden the tax base, allowing the same amount of tax revenue to be collected with lower tax rates. What about the tax rate structure? Would the federal personal income tax be a better tax if it were more progressive or less progressive? This question involves a trade-off. Making the tax more progressive would help in achieving the goal of equalizing the distribution of income. Increasing income equality might increase the consumer satisfaction produced from the limited resources (see Chapter 31). Making the tax less progressive would help in achieving the goal of minimizing the deadweight loss imposed by the tax. The best choice for the rate structure depends on the relative value assigned to each goal. FOR REVIEW ONLY - NOT FOR DISTRIBUTION 13 - 7 Taxes, Deficits, and the National Debt

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    PRINCIPLES OF ECONOMICS JEFF HOLT S

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    Principles of Economics, 6th Editio

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    16. Study Guide for Chapter 7 17. C

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    11. Appendix: Book Review - “The

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    20. Appendix: The NCAA Cartel 21. S

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    Introduction: A Brief History of U.

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    In the twentieth century, per capit

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    Appendix: The 35 Largest National E

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    Multiple Choice: ___ 1. The Jamesto

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    2. Describe the economic cost of th

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    Chapter 1 Scarcity and Choices The

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    Example 5B: At the end of 1982, the

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    Example 11: When Cindy quits her jo

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    consequences may result in failure

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    An upward sloping curve (as in Exam

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    In making decisions, humans tend to

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    5. ______________________ _________

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    ___ 13. If the value of one variabl

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    Y Point X Y A 0 1 B 3 3 C 6 5 D 9 7

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    Chapter 2 Trade and Economic System

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    Example 4B: The following quantitie

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    1. An increase in the quantity of r

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    3. For whom to produce? This is det

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    The graph below illustrates the shi

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    The two primary economic systems ar

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    ___ 12. The capitalist vision sees

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    ___ 25. According to the book “Ca

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    Chapter 3 Demand, Supply, and Equil

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    . For inferior goods, income and de

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    The same information can be placed

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    Not only does a free market elimina

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    $7 - 6 - 5 - S 3 S1 S 2 Price 4 - 3

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    Example 17: The graph below illustr

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    Questions for Chapter 3 Fill-in-the

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    ___ 12. Assuming a market originall

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    $8 - 7 - 6 - 5 - Price 4 - 3 - 2 -

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    Chapter 4 Inflation and Unemploymen

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    Computing the Rate of Inflation The

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    Full Employment Though unemployment

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    3. Cyclical unemployment - due to d

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    During the Great Depression, the ec

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    Appendix: Think Like an Economist -

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    Answer questions 8. and 9. based on

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    ___ 25. The extension of unemployme

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    Chapter 5 Measuring Total Output: G

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    5. Leisure. Leisure time is by defi

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    The U.S. is a high per capita GDP c

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    Example 17: In “An International

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    The simple circular flow diagram be

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    ___ 3. Which of the following would

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    2. Explain what nonproduction trans

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    Chapter 6 The Aggregate Market The

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    Example 2C: Assume the same facts a

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    Example 5B: The price of crude oil

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    Price Level Real GDP SRAS AD 2 AD 1

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    Appendix: Why the Aggregate Demand

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    ___ 3. DEF Company can invest in ne

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    2. List and explain the two factors

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    Chapter 7 Classical Economic Theory

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    Notice that the investment demand c

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    Long-Run Equilibrium If Real GDP is

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    Example 6B: When the economy is in

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    Laissez-faire If the economy is sel

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    ___ 5. According to Say’s Law: a.

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    3. On the graph below, draw an aggr

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    Chapter 8 Keynesian Economic Theory

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    Example 2B: The graph below illustr

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    Example 5: Assume that the table be

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    Notice on the graph on the previous

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    According to Keynesian theory, a ch

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    “The General Theory” also inclu

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    ___ 8. If the consumption function

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    3. If the MPC is .667, and investme

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    Chapter 9 Fiscal Policy The basic e

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    Keynesian Fiscal Policy Theory and

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    Example 5A: The federal government

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    The Laffer Curve What will happen t

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    Appendix: The Importance of Incenti

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    ___ 4. A decrease in government exp

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    2. Explain what automatic stabilize

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    Chapter 10 Money, Money Creation, a

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    Example 4B: The castaways on Gillig

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    Looking at the balance sheet below,

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    competitive disadvantage. But dumpi

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    is only 25% as productive as before

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    Smith was skeptical of government a

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    ___ 4. For Country X, what is the o

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    ___ 18. Frédéric Bastiat’s “P

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    4. On the graph below: (1) What is

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    Chapter 17 Elasticity We are often

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    Example 4A: What is price elasticit

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    Example 5A: Gertie’s Gas and Go i

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    Example 10A: When the price of Good

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    Example 13B: On the graph below, su

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    $7 - 6 - 5 - Price 4 - 3 - 2 - 1 -

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    In the long run, would the deadweig

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    ___ 7. The factors that determine w

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    3. a. Which price (or prices) from

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    Chapter 18 Utility The basic econom

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    Nonetheless, society generally assu

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    Example 9: Capital City operates a

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    Marginal rate of substitution - the

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    The diamond-water paradox is the ob

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    Complete the table below to answer

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    4. The graph below shows indifferen

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    Chapter 19 The Firm The basic econo

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    than contributing to team productio

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    1. Difficulty in raising large amou

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    Corporations also use self-financin

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    Example 24: A blacksmith who produc

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    For financing needs, proprietorship

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    ___ 13. Corporations: a. are comple

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    5. List two things that the absence

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    Chapter 20 Production and Costs The

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    In Example 5B, Birdwell finds that

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    variable cost initially decreases,

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    Quantity TC MC AFC AVC ATC 0 240 X

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    If the scale of operation is increa

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    average total cost. Average fixed c

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    ___ 11. Concerning the cost curves:

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    5. Complete the following cost tabl

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    Chapter 21 Perfect Competition The

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    Even though a perfect competitor ca

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    Example 6C: This example builds on

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    At what price will there be neither

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    Appendix: Perfect Competition in th

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    Multiple Choice: ___ 1. A perfect c

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    ___ 17. Perfect competition: a. req

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    Answers for Chapter 21 Fill-in-the-

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    Chapter 22 Monopoly Of the four mar

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    3. Exclusive ownership of an essent

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    maximizing quantity (4 units) creat

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    $22 - 20 - 18 - 16 - 14 - Deadweigh

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    2. Negotiating, beginning at a high

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    Legal barriers are created by gover

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    ___ 8. The slope of the demand curv

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    Price Quantity 3. List some of the

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    Chapter 23 Monopolistic Competition

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    For Percomp (the perfect competitor

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    Example 7A: The graph below represe

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    Example 9: The Organization of the

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    Example 12 illustrates the dilemma

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    its current price and quantity. The

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    ___ 14. Game theory: a. is a method

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    Answers for Chapter 23 Fill-in-the-

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    Chapter 24 Factor Markets The basic

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    $ $240 - 200 - 160 - 120 - 80 - 40

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    Since producers will attempt to equ

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    2. Differences in nonmoney aspects

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    were his strikeouts, walks, and hom

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    ___ 3. To maximize profits, a produ

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    ___ 19. According to the book, “M

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    Multiple Choice: 1. a. 8. c. 15. d.

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    Chapter 25 Labor Unions The primary

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    The elasticity of demand for union

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    Example 4A: Assume that the graph b

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    Notice from the graph in Example 6

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    Wage Factory A Quantity of Labor S

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    As a cartel, a labor union faces a

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    ___ 10. For a monopsony: a. there i

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    3. The graph below represents a lab

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    Chapter 26 Interest, Present Value,

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    An increase in expected rates of re

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    An asset is valuable because we exp

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    Example 13B: General Ordnance prove

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    Appendix: Present Value Table One f

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    ___ 4. An increase in expected rate

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    Problems: 1. List and explain the t

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    Chapter 27 Market Failure The basic

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    External Benefit If a market genera

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    Example 2: To encourage the consump

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    $100 - 90 - 80 - MSC 70 - $ 60 - 50

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    A common good is nonexcludable. Non

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    Study Guide for Chapter 27 Chapter

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    ___ 5. What government policy would

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    4. Based on the information on the

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    Chapter 28 Public Choice and Govern

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    Candidates and the Median Voter Mod

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    Example 8: According to State and F

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    Example 10: When Elvis Presley was

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    4. Pessimistic bias. This is the te

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    ___ 5. An elected official will: a.

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    2. If a certain policy will yield s

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    Chapter 29 Government Regulation of

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    underproduction is the amount that

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    micromanagement results in business

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    market. They may agree with their c

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    Questions for Chapter 29 Fill-in-th

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    ___ 10. The public interest theory

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    4. List the four types of costs imp

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    Chapter 30 Agriculture and Health C

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    weather may cause bumper crops. Bad

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    Security and Rural Investment Act o

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    Example 12: From 1960 to 2013, the

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    1. NHI would provide universal heal

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    d. Insurance providers are not allo

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    Study Guide for Chapter 30 Chapter

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    Answer questions 7. through 10. by

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    ___ 21. If there were no individual

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    Chapter 31 Income Distribution and

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    Income is more equally distributed

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    over a typical career is the accumu

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    Ideal Income Redistribution The ide

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    Poverty - a family whose income fal

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    Appendix: Income Inequality around

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    How is this story an analogy for th

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    ___ 2. In 2013, the Lowest Income 6

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    Problems: 1. Explain the two primar

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    Absolute advantage - when one natio

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    Fiat money - money by government de

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    Nonrivalrous good - a good for whic

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    Absolute advantage, 16-9 Absolute e

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    “Company town”, 25-6 Comparativ

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    Eli Lilly and Company, 22-1 Emergen

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    Houston, Texas, 15-10 Human capital

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    Market, 3-1, 3-8-9 Market basket, 4

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    Political bias, 9-4, 12-7 Political

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    Short run production, 20-2-3 Short-

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    Upturns, 9-4 USDA, 27-9, 30-1-2, 30

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