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3. Borrowers do not have

3. Borrowers do not have to seek out numerous savers in order to borrow a large sum. Example 10A: Borrower wishes to borrow $13,000,000 for business expansion. If Borrower attempts to borrow the money directly from savers, Borrower might have to enter into loan agreements with hundreds of individual savers in order to borrow such a large amount. The transaction cost of the many loan agreements would be very high. Example 10B: Borrower borrows the $13,000,000 from 1 st Bank. Borrower will enter into only one loan agreement. The bank will have received deposits from thousands of savers, and can bring the savers and Borrower together at a much lower transaction cost. Appendix: The Great Depression Classical economic theory was the predominant theory in industrialized nations from the time of Adam Smith until the Great Depression of the 1930s. The free market laissez-faire policies followed by the industrialized world during this time corresponded with a period of unprecedented economic growth. Then along came the Great Depression. Economic downturns, some quite severe, had occurred periodically in the U.S. between 1776 and 1929. But no downturn was as severe or as long-lasting as the Great Depression of the 1930s. The Great Depression was many times more severe than the Great Recession of 2007-09. During the Great Recession, Real GDP fell by about 3%. Example 11: Between 1929 and 1933, Real GDP decreased by over 26%. Investment spending collapsed. The consumer price index fell by 24%. The deflation (decrease in the price level) caused the real prime lending rate to rise from 6% in 1929 to 14% in 1931. The unemployment rate increased from 3.2% in 1929 to 24.9% in 1933. After the economy bottomed out in 1933, a weak recovery began. Another recession occurred in 1938. Real GDP was only slightly greater in 1938 than it had been in 1929. Investment spending did not reach the 1929 level until 1941. The unemployment rate did not fall below 14% until 1941, when it was still 9.9%. According to classical economic theory, a market economy is self-regulating and will automatically adjust to Natural Real GDP. During the Great Depression, the U.S. economy did not automatically adjust to Natural Real GDP. The table in Example 12 below illustrates the severity and the length of the Great Depression. Example 12: Real GDP Year (2009 Base)_ Inflation Rate Unemployment Rate 1929 $1,056.6 billion 0.0% 3.2% 1930 966.7 billion -2.3% 8.7% 1931 904.8 billion -9.0% 15.9% 1932 788.2 billion -9.9% 23.6% 1933 778.3 billion -5.1% 24.9% 1934 862.2 billion 3.1% 21.7% 1935 939.0 billion 2.2% 20.1% 1936 1,060.5 billion 1.5% 16.9% 1937 1,114.6 billion 3.6% 14.4% 1938 1,077.7 billion -2.1% 19.0% 1939 1,163.6 billion -1.4% 17.2% 1940 1,266.1 billion 0.7% 14.6% 1941 1,490.3 billion 5.0% 9.9% FOR REVIEW ONLY - NOT FOR DISTRIBUTION 12 - 7 Monetary Policy

Keynesian Theory of the Great Depression Keynesian economists blame the Great Depression on the inherent instability of a market economy. The stock market crash of 1929 caused investors to become extremely pessimistic. The extreme pessimism of investors caused a collapse in investment spending. The decrease in investment spending led to a multiplied decrease in Real GDP. The federal government might have triggered a rapid recovery with proper fiscal and monetary policy. But the federal government’s fiscal policy was not truly expansionary until the military buildup corresponding with World War II. The Fed’s monetary policy was not intentionally contractionary from 1929 to 1933. But the large number of bank failures caused the money supply to decrease by 25% from 1929 to 1933. Nearly 10,000 banks failed from 1929 to 1933. The bank failures directly decreased checkable deposits and motivated large amounts of withdrawals from banks that did not fail. With the coming of World War II, the government’s fiscal and monetary policy became strongly expansionary. Example 13: Federal government expenditures increased from $15.1 billion in 1940 to $105.5 billion in 1944. The money supply (M1) increased from $41.9 billion in 1940 to $90.7 billion in 1944. The expansionary fiscal and monetary policy finally restored full employment. The unemployment rate dropped from 14.6% in 1940 to 1.2% in 1944. The recovery of the economy corresponding to the expansionary fiscal and monetary policy associated with World War II supports the Keynesian belief that proper fiscal and monetary policy can stabilize the economy. Classical Theory of the Great Depression Classical economists disagree with the Keynesian interpretation of the Great Depression. Classical economists lay the blame for the severity and length of the Great Depression on government policy. What began as a normal downturn in the business cycle was turned into an economic collapse by two government policy mistakes. The Federal Reserve System failed in its roles as lender of last resort and controller of the money supply. Nearly 10,000 banks failed causing a 25% decrease in the money supply. The decrease in the money supply caused significant deflation. (See the table in Example 12.) Significant deflation can have a catastrophic affect on financial markets. A deflation rate of 9% (as occurred in 1931) means that if the equilibrium real interest rate (the rate that equalizes savings and investment) is 4%, the nominal interest rate would have to be negative 5%. A negative nominal interest rate is impossible. Lenders will not be willing to pay borrowers to borrow their money. Deflation in essence causes a price floor on interest rates, leading to a surplus of savings (or a shortage of investment). The deflation of the early 1930s caused real interest rates to skyrocket. The real prime lending rate rose to 14% in 1931. The high real interest rates caused investment spending to collapse. Example 14: Real investment spending decreased by over 83% between 1929 and 1932. The second government policy mistake was the Smoot-Hawley Tariff, enacted in 1930. This protectionist tariff led to retaliatory tariff increases by U.S. trading partners, leading to a collapse in international trade. (For a more detailed discussion of the relationship between the stock market crash of 1929, the Smoot-Hawley Tariff, and the Great Depression, see the appendix at the end of Chapter 7.) When the monetary situation was finally stabilized in 1933, the economic recovery was hobbled by the excessive (and inconsistent) government intervention of President Franklin Roosevelt’s New Deal. FOR REVIEW ONLY - NOT FOR DISTRIBUTION Monetary Policy 12 - 8

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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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    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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    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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    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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    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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    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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    Chapter 17 Elasticity We are often

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    Example 4A: What is price elasticit

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    Example 10A: When the price of Good

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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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    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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    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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    At what price will there be neither

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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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    Wage Factory A Quantity of Labor S

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    Chapter 26 Interest, Present Value,

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    An increase in expected rates of re

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

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