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On February 17, 2009,

On February 17, 2009, the federal government enacted a $787 billion economic stimulus plan, consisting mainly of new federal spending. On December 17, 2010, the federal government enacted an $858 billion economic stimulus plan, consisting of tax cut extensions, new tax cuts, and new federal spending. The Essential Cause of the Housing Bubble The severe recession that began in December of 2007 was caused by the bursting of the housing bubble and the resulting credit crisis. Each of the four primary causes played an important role in creating the housing bubble and the credit crisis. The combination of all four causes created a type of “perfect storm” causing the housing bubble to be extreme and the resulting credit crisis to be severe. Three of the causes, though they contributed to the housing bubble, were not essential to the development of the bubble. Low mortgage interest rates, low short-term interest rates, and relaxed mortgage lending standards all contributed to the housing bubble. But the absence of any of these three causes would not necessarily have prevented the housing bubble. For example, if mortgage interest rates had not been at historically low levels, a housing bubble could still have developed. A housing bubble occurred in the late 1980s at much higher mortgage interest rates. Likewise, without low short-term interest rates or relaxed mortgage lending standards, there still could have been a housing bubble, though it would have been less extreme. The one essential cause of the housing bubble was irrational exuberance. The housing bubble would not have occurred without the widespread belief that home prices would continue to rise. And irrational exuberance contributed to the other three causes. Mortgage interest rates would not have been so low if foreign investors and credit rating agencies had not believed that U.S. home prices would keep rising. Low short-term interest rates would not have led to such extensive use of ARMs and such a high degree of leveraging without irrational exuberance. And relaxed standards for mortgage loans would not have led to such a large increase in subprime mortgages without irrational exuberance. Appendix: Quantitative Easing During the credit crisis resulting from the bursting of the housing bubble, the Fed began using a new monetary policy called quantitative easing. Quantitative easing is a variation on traditional open market operations. In traditional open market operations, the Fed buys or sells U.S. government securities in the open market. The purpose is to increase or decrease the money supply, with an ultimate goal of controlling the federal funds rate. Example 18: From September of 2007 to December of 2008, the Fed aggressively bought shortterm U.S. government securities, increasing the money supply and lowering the target for the federal funds rate from 5.25% to a range of 0.00%-0.25%. With the federal funds rate target lowered to a near-zero range, the Fed could no longer drive short-term interest rates lower with traditional open market operations. The Fed took a new approach, which came to be known as quantitative easing. Quoting from the Federal Reserve website: “Since late 2008, the Federal Reserve has greatly expanded its holding of longer-term securities via a series of asset purchase programs with the goal of putting downward pressure on longer-term interest rates and thus supporting economic activity and job creation by making financial conditions more accommodative.” Quantitative easing has resulted in the Fed increasing the assets on its balance sheet from around $900 billion in August of 2008 to over $4.4 trillion in August of 2014. The composition of the Fed’s assets has also changed. Prior to quantitative easing, the bulk of the Fed’s assets were short-term U.S. government securities. In August of 2014, the two largest Fed assets were U.S. government securities (over $2.4 trillion) and mortgage-backed securities (almost $1.7 trillion). In FOR REVIEW ONLY - NOT FOR DISTRIBUTION 11 - 11 The Federal Reserve System

August of 2014, almost all of the U.S. government securities held by the Fed were long-term securities, with maturities of greater than one year. Quantitative easing has also led to a large increase in the money supply (M1). At the end of 2008, the money supply was around $1,600 billion. By the end of July, 2014, the money supply was over $2,800 billion. Like traditional open market operations, quantitative easing increases bank reserves. This would normally be expected to stimulate the economy by increasing bank lending. However, banks have chosen to hold much of the newly created reserves as excess reserves. Example 19: In August of 2008, bank excess reserves totaled less than $2 billion. By July of 2014, bank excess reserves totaled more than $2.6 trillion. (Information from the Federal Reserve Bank of St. Louis.) Since banks have chosen to hold a large amount of excess reserves, quantitative easing has not stimulated the economy as much as hoped. The large amount of excess reserves accumulated also creates the risk of significant inflation in the future. Study Guide for Chapter 11 Chapter Summary for Chapter 11 The Federal Reserve System (Fed) is the U.S. central bank. The governing body of the Fed is the Board of Governors, headed by the Chair of the Board of Governors (Janet Yellen). The Fed performs a number of important functions, including; (1) control the money supply, (2) supervise and regulate banking institutions, (3) serve as the lender of last resort, (4) hold banks’ reserves, (5) supply the economy with currency, and (6) provide check-clearing services. The Fed influences the money supply by changing the monetary base, which is currency in circulation plus bank reserves. When the Fed makes a purchase or a sale, the monetary base changes. When the monetary base changes, the money supply changes by a multiplied amount. The actual money multiplier is equal to the change in the money supply divided by the change in monetary base. The Fed’s primary tool for controlling the money supply is open market operations; the Fed buying and selling U.S. government securities in the open market. If the Fed buys securities in the open market, bank reserves increase, which leads to money creation. To reduce the money supply, the Fed would sell securities. The Fed can also control the money supply by changing the reserve requirement or by changing the discount rate. Lowering the reserve ratio would increase the money supply. Lowering the discount rate would increase the money supply. The economy entered into a recession in December of 2007. Real GDP, the unemployment rate, the stock market, and the federal budget were all strongly affected by the recession. The primary cause of the recession was the credit crisis arising from the bursting of the housing bubble. The four primary causes of the housing bubble were; (1) low mortgage interest rates, (2) low short-term interest rates, (3) relaxed standards for mortgage loans, and (4) irrational exuberance. Mortgage interest rates in the U.S. were kept low by an influx of savings from other countries. Much of this saving was invested in mortgage-backed securities issued by investment banks. The low mortgage interest rates contributed to the housing bubble by keeping monthly mortgage payments affordable for more buyers even as home prices rose. FOR REVIEW ONLY - NOT FOR DISTRIBUTION The Federal Reserve System 11 - 12

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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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    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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Chapter 5: Supply