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The Bursting of the

The Bursting of the Housing Bubble and the Credit Crisis Home prices reached their peak in the July of 2006. They did not fall drastically at first. Nonetheless, mortgage default rates began to rise as soon as home prices began to fall. Example 14: Home prices fell by less than 2% from July of 2006 to January of 2007. Foreclosure start rates increased by 43% over the last two quarters of 2006, and increased by 75% in 2007 compared to 2006. Speculators who bought homes (often with no money down) simply walked away from the property when the home price fell. Many never made even the first monthly payment. Homeowners with adjustable rate mortgages found that they could not refinance, because the decrease in home prices meant that they had negative equity in their homes. When their mortgage interest rates adjusted upward, their monthly payment was no longer manageable. Example 15: Foreclosure rates for adjustable rate mortgages increased much more than foreclosure rates for fixed rate mortgages. From the 2 nd quarter of 2006 to the end of 2007, foreclosure rates for fixed rate mortgages increased by about 55% (prime) and about 80% (subprime). During this same time period, foreclosure rates for ARMs increased by about 400% (prime) and about 200% (subprime). (Information is from “Anatomy of a Train Wreck” by Stan J. Liebowitz of the Independent Institute.) Just as rising home prices reinforced the continuing rise in home prices, falling home prices reinforced the continuing fall in home prices. The increase in foreclosures added to the inventory of homes available for sale. This further decreased home prices, putting more homeowners into a negative equity position and leading to more foreclosures. The increase in foreclosures also decreased the value of mortgage-backed securities. This made it difficult for investment banks to issue new mortgage-backed securities, eliminating a major source of financing for new mortgage loans, and contributing to the continuing decline in home prices. The bursting of the housing bubble led to enormous losses. Some of those losses were incurred by homeowners, particularly those who bought their homes or who took out home equity lines of credit against the value of their homes too close to the peak. Most of the losses were not incurred by homeowners, but by the financial system. Large losses were incurred by: 1. Mortgage lenders. Since the housing bubble burst, a number of the largest mortgage lenders have either been acquired (e.g. Countrywide Financial by Bank of America), have filed for bankruptcy (e.g. New Century Financial), or have been liquidated. 2. Investment banks. Since the housing bubble burst, the five largest U.S. investment banks have either filed for bankruptcy (Lehman Brothers), been acquired by other firms (Bear Sterns and Merrill Lynch), or have become commercial banks subject to greater regulation (Goldman Sachs and Morgan Stanley). 3. Foreign investors (mainly banks and governments) who had invested in mortgage-backed securities. 4. Insurance companies (e.g. AIG) who had sold credit default swaps. Credit default swaps are a type of contract that insures against the default of debt instruments, such as mortgage-backed securities. The bursting of any housing bubble would be expected to have a negative effect on the economy for two reasons: First, home construction is an important economic activity and the decline in home construction would reduce GDP. Second, the decrease in home prices would also reduce household consumption due to the wealth effect. (See Example 1A on page 6-2.) FOR REVIEW ONLY - NOT FOR DISTRIBUTION But the bursting of this housing bubble caused more severe and widespread harm than would be predicted from just these two reasons. As mentioned previously, most of the losses were suffered 11 - 9 The Federal Reserve System

y the financial system, not by the homeowners. The bursting of the housing bubble sent a shock through the entire financial system, increasing the perceived credit risk throughout the economy, as indicated by the TED spread. The TED spread is the difference between the interest rate on three-month U.S. treasury bills and the interest rate on three-month interbank loans as measured by the London Interbank Offered Rate (LIBOR). Example 16: The TED spread is considered a good indicator of the perceived credit risk in the economy. Historically, the TED spread has ranged between .2% and .5%. In August of 2007, the TED spread jumped above 1% and generally stayed between 1% and 2% until mid-September of 2008, when it began spiking upward, reaching a record level of over 4.5% on October 10, 2008. The TED spread finally fell back below .5% in June of 2009. The increased perceived credit risk throughout the economy meant that not only would home buyers find it more difficult to obtain financing, but so would commercial real estate investors, corporations seeking financing for investment, municipalities seeking to issue new bonds, etc. Example 17: Real investment spending decreased by 32% from the third quarter of 2007 to the third quarter of 2009. By contrast, real consumption spending decreased by only 2% over this time period. Government Intervention The bursting of the housing bubble did not immediately create widespread credit problems. The TED spread did not significantly increase until August of 2007. When the credit crisis arising from the bursting of the housing bubble became apparent, the federal government began to intervene in the economy in unprecedented ways. In September of 2007, the Federal Reserve began to take steps to attempt to ease the credit crisis. On September 18, 2007, the Fed lowered the target for the federal funds rate from 5.25% to 4.75%. Over the succeeding 15 months, the Fed would lower the rate nine more times, eventually to a range of 0.00%-0.25% on December 16, 2008. In December of 2007, the Fed began to lend billions of dollars directly to financial institutions (through such programs as the Term Auction Facility) to enhance the Fed’s ability to provide liquidity to the financial system. In February of 2008, the federal government enacted the Economic Stimulus Act of 2008. This was a $168 billion stimulus plan, consisting primarily of tax rebates to individual taxpayers. The act also increased the dollar size of mortgages eligible for purchase by Fannie Mae and Freddie Mac. In March of 2008, the Fed provided a $29 billion loan to facilitate the purchase of Bear Stearns, an investment bank on the brink of bankruptcy, by JPMorgan Chase. From August of 2008 to December of 2008, the Fed increased the money supply (M1) by more than 14%. In late 2008, the Fed began using quantitative easing, a variation on traditional open market operations. (See the appendix at the end of the chapter.) On September 7, 2008, the Federal Housing Finance Agency placed Fannie Mae and Freddie Mac into conservatorship. With the conservatorship, the federal government committed to provide up to $100 billion in additional capital to each of the GSEs. On September 16, 2008, the Fed provided an $85 billion loan to AIG, the largest insurance company in the world, to prevent its bankruptcy. The Fed received an 80% equity stake in the company. The loans and lines of credit provided to AIG would eventually grow to over $180 billion. FOR REVIEW ONLY - NOT FOR DISTRIBUTION On October 3, 2008, the $700 billion Emergency Economic Stabilization Act of 2008 was enacted. The initial plan was to buy up illiquid mortgage assets from banks. Instead, the bailout money was used to make direct investments in financial institutions. The Federal Reserve System 11 - 10

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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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  • Page 168 and 169: Demand-side One-shot Inflation Exam
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  • Page 190 and 191: On February 17, 2009, the federal g
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    The table below shows the economic

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    will increase both Real GDP and per

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    ___ 8. Which of the following is co

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    ___ 26. The opinion that economic g

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    Chapter 15 Less Developed Countries

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    Example 8: Countries A, B, C, and D

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    Obstacles to Economic Development f

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    c. Restrictions on international tr

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    Appendix: Book Review - “The Powe

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    Example 25: In Brazil, about half t

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    Study Guide for Chapter 15 Chapter

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    ___ 13. Among the counterproductive

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    4. List four ways that governments

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    Chapter 16 International Trade The

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    Other Benefits of Free Internationa

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    Example 6: The graph below illustra

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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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