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There are a total of 7 questions. Each answer needs to be 150 words in length. The questions and the short readings are attached. Due 03/12/2013 21:00 EST. Willing to pay $10.
Case StudiesCase Studies
CONSUMER CHOICE AND DEMAN
D
Case 6.1: Water, Water, Everywhere
Centuries ago, economists puzzled over the price of diamonds relative to the price of water. Diamonds are mere
bling—certainly not a necessity of life in any sense. Water is essential to life and has hundreds of valuable uses.
Yet diamonds are expensive, while water is cheap. For example, the $10,000 spent on a high-quality one-carat
diamond could buy about 10,000 bottles of water or about 2.8 million gallons of municipally supplied water (which
sells for about 35 cents per 100 gallons in New York City). However measured, diamonds are extremely expensive
relative to water. For the price of a one-carat diamond, you could buy enough water to last two lifetimes.
How can something as useful as water cost so much less than something of such limited use as diamonds? In 1776, Adam Smith dis-
cussed what has come to be called the diamonds-water paradox. Because water is essential to life, the total utility derived from water greatly
exceeds the total utility derived from diamonds. Yet the market value of a good is based not on its total utility but on what consumers are willing
and able to pay for an additional unit—that is, on its marginal utility. Because water is so abundant in nature, we consume it to the point where
the marginal utility of the last gallon purchased is relatively low. Because diamonds are relatively scarce compared to water, the marginal utility
of the last diamond purchased is relatively high. Thus, water is cheap and diamonds expensive. As Ben Franklin said “We will only know the
worth of water when the well is dry.”
Speaking of water, sales of bottled water are growing faster than any other beverage category—creating a $15 billion U.S. industry, an
average of 25 gallons per person in 2010. Bottled water ranks behind only soft drinks in sales, outselling coffee,milk, and beer. The United
States offers the world’s largest market for bottled water—importing water from places such as Italy,France, Sweden, Wales, even Fiji. “Water
bars” in cities such as Newport, Rhode Island, and San Francisco feature bottled water as the main attraction. A 9-ounce bottle of Evian water
costs$1.49. That amounts to $21.19 per gallon, or nearly 10 times
more than gasoline. Youthink that’s pricey? Bling H
2
O is available in
bottles decorated with Swarovski crystals and sells for more than $50
a bottle—that’s about 100 times more than gasoline.
Why would consumers pay a premium for bottled water when
water from the tap costs virtually nothing? After all, some bottled water
comes from municipal taps (for example, New York City water is also
bottled and sold under the brand name Tap’dNY). First, many people
do not view the two as good substitutes. Some people have concerns
about the safety of tap water, and they consider bottled water a
healthy alternative (about half those surveyed in a Gallup Poll said they
won’t drink water straight from the tap). Second, even those who drink
tap water fi nd bottled water a convenient option away from home.
And third, some bottled water is now lightly fl avored or fortifi ed with
vitamins. People who buy bottled water apparently feel the additional benefi t offsets the additional cost.
Fast-food restaurants now offer bottled water as a healthy alternative to soft drinks. Soft-drink sales have been declining for more than a
decade as bottled water sales have climbed. But if you can’t fi ght ’em, join ’em: Pepsi’s Aquafi na is the top-selling bottled water in America,
and Coke’s Dasani ranks second.
SOURCES: Dana Cimilluca et al., “Coke Near Deal for Bottler,” Wall Street Journal, 25 February 2010; Jack Healy, “Five-cent Deposits Set for Bottled Water,” New York Times,
24 October 2009; and Charles Duhigg, “That Tap Water Is Legal But May Be Unhealthy,” New York Times, 16 December 2009. The Defi nitive Bottled Water site is http://www.
bottledwaterweb.com/,and the New York City drinking water department is at http://www.nyc.gov/html/dep/html/drinking_water/index.shtml.
QUESTIONS
1. What is the diamonds-water paradox, and how is it explained?
2. Use the same reasoning as in question 1 to explain why bottled water costs so much more than tap water.
3. If consumers paid an amount for water that refl ected the value of the total benefi ts they receive from consuming it, then what would
consumer surplus equal?
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Case 6.2: The Marginal Value of Free Medical Care
Certain Americans, such as the elderly and those on welfare, receive government-subsidized medical care. State and federal taxpayers spend
more than $750 billion a year providing medical care to 94 million Medicare and Medicaid recipients, or more than $8,000 per benefi ciary.
Medicaid is the large stand fastest growing spending category in most state budgets. Benefi ciaries pay only a tiny share of Medicaid costs;
most services are free.
The problem with giving something away is that a benefi ciary consumes it to the point where the marginal value reaches zero, although
the marginal cost to taxpayers can be sizable. This is not to say that people derive no benefi t from these programs. Although benefi ciaries may
attach little or no value to the fi nal unit consumed, they likely derive a substantial consumer surplus from all the other units they consume. For
example, suppose that the fi gure below represents the demand for health care by Medicaid benefi ciaries. If the price they face is zero, each
benefi ciary consumes health care to the point where the demand curve intersects the horizontal axis—that is, where his or her marginal valu-
ation is zero. Although they attach little or no value to their fi nal unit of Medicaid-funded health care, their consumer surplus is the entire area
under the demand curve.
One way to reduce the cost to taxpayers without signifi cantly harming benefi ciaries is to charge a token amount—say, $1 per doctor visit.
Benefi ciaries would eliminate visits they value less than $1. This practice would yield signifi cant savings to taxpayers but would still leave
benefi ciaries with abundant health care and a substantial consumer surplus (measured in the fi gure below as the area under the demand curve
but above the $1 price). In a Medicaid experiment in California, this $1 charge reduced offi ce visits by 8 percent compared to the control group.
Medical care, like other goods and services, is also sensitive to its time cost. For example, a 10 percent increase in the average travel time to a
free outpatient clinic reduced visits by 10 percent. Similarly, when the relocation of a free health clinic at one college increased students’ aver-
age walking time by 10 minutes, visits dropped 40 percent.
Another problem with giving something away is that benefi ciaries
are less vigilant about getting honest value, and this may increase
the possibility of waste, fraud, and abuse. According to President
Obama, “improper payments” for Medicaid and Medicare cost
taxpayers nearly $100 billion in 2009. Medicaid fraud has replaced
illegal drugs as the top crime in Florida. Crooks were charging the
government for medical supplies that were not delivered or not
needed (some supposed benefi ciaries were dead). People won’t tol-
erate padded bills and fake claims if they have to pay their own bills.
Finally, program benefi ciaries have less incentive to pursue
healthy behaviors themselves in their diet, their exercise, and the
like. This doesn’t necessarily mean certain groups don’t deserve
heavily subsidized medical care. The point is that when something
is free, people consume it until their marginal value is zero, they pay
less attention to getting honest value, and they take less personal
responsibility for their own health.
Some Medicare benefi ciaries visit one or more medical specialists most days of the week. Does all this medical attention improve their
health care? Not according to a long running Dartmouth Medical School study. Researchers there found no apparent medical benefi t and even
some harm from such overuse. Even a modest money cost or time cost would reduce utilization, yet would still leave benefi ciaries with quality
health care and a substantial consumer surplus. Research suggests that up to 30 percent of all medical care is unnecessary.
Federal legislation in 2010 expanded the coverage of Medicaid and extended insurance coverage to many without it. Research by Michael
Anderson and others suggests that one result will be a “substantial increase in care provided to currently uninsured individuals.” No question,
better health care can improve the quality of life, but overusing a service because the price is zero also wastes scarce resources.
SOURCES: Michael Anderson, Carlos Dobkin, and Tal Gross, “The Effects of Health Insurance Coverage on the Use of Medical Services,” NBER Working Paper 15823 (March 2010);
David Card, Carlos Dobkin, and Nicole Maestras, “The Impact of Nearly Universal Insurance Coverage on Health Care Utilization,” American Economic Review, 98 (December2008):
2242–2258; Elliot Fisher et al., “The Implications of Regional Variation in Medicare Spending,” Annals of Internal Medicine, 18 February 2003; Gina Kolata, “Law May Do Little
to Help Curb Unnecessary Care,” New York Times, 29 March 2010; and Steven Rhoads, “Marginalism,” in The Fortune Encyclopedia of Economics, edited by D. R. Henderson
(New York: Warner, 1993): 31–33. A transcript of President Obama’s remarks about ‘improper payments’ is at http://www.whitehouse.gov/the-press-offi ce/remarks-president-
health-insurance-reform-st-charles-mo. For more on Medicare and Medicaid, go to http://www.cms.hhs.gov/.
QUESTIONS
1. Medicare recipients pay a monthly premium for coverage, must meet an annual deductible, and have a co-payment for doctors’ offi ce
visits. What impact would an increase in the monthly premium have on their consumer surplus? What would be the impact of a reduction
in co-payments?
2. President George W. Bush introduced some new coverage for prescription medications. What is the impact on consumer surplus of offering
some coverage for prescription medication?
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Market Demand and Consumer Surplus
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Case StudiesCase Studies
TRACKING THE U.S. ECONOMY
Case Study 6.1: GDP and The State of the USA
GDP estimates have been refi ned for decades and are arguably the most complex data aggregation effort in the
world. But they have their limits, as discussed already, and they have their critics. One criticism is that GDP leaves
out much of what’s going on in the nation—with health care, the environment, the family, energy use, and so on.
One challenge to GDP as the primary indicator of national progress is coming from a nonprofi t group that has
developed a Web site to bring together hundreds of indicators. The idea is to help Americans assess the progress of
the United States by using quality data selected by experts.
First, a little background. In 2003, a team at the U.S. Government Accountability Offi ce, the investigative arm of Congress, was looking for
alternatives to GDP to assess national progress. The team became an independent nonprofi t agency in 2007 and took the name “The State
of the USA.” With startup funding from the Gates, Hewlett, MacArthur, and Rockefeller foundations, the group set out to identify data that
would amount to a report card on how the country is doing in specifi c areas—such as health care, education, the environment, safety, energy,
transportation, the economy, the family, and so forth. The goal is to help citizens and leaders assess what progress has been made and where
we need to improve.
The effort got a big boost from a small provision in the massive 2010 health care bill that requires Congress to help fi nance and oversee
a “key national indicator system.” State of the USA will become that system, overseen by the National Academy of Sciences, a group of pre-
eminent scholars established by Abraham Lincoln in 1863 to “investigate, examine, experiment, and report upon any subject of science or art”
whenever called upon to do so by any department of the government (half the 20 economists in the National Academy are Nobel laureates).
Along with the federal authorization came federal funding totaling $70 million between 2010 and 2018.
The objective is not so much to replace GDP as the primary measure of economic performance, but to broaden the conversation and the
debate by including many more data series. Instead of just having one gauge on the dashboard, GDP, there would be many gauges. The State
of the USA Web site went live in 2010, and is accessible for free. Eventually, The State of the USA plans to offer about 300 indicators. Rather
than develop original data, the site compiles and displays data gathered by others. Despite the number of data series, the group says the site
will be selective, not encyclopedic. For example, in health care alone the government collects about 1,000 different measures. The State of
the USA offers what they claim are the 20 most crucial health care measures. The group says its objective is not to interpret the data but to
disseminate it in a strictly nonpartisan manner.
The idea is to offer data in a form that can be easily shared to promote as wide a distribution as possible. Data will be available on the
national level, state level, and as far down the jurisdictional chain as possible. For example, one of the 20 health care measures reports smok-
ing rates by state (West Virginia is the highest and Utah is the lowest). The State of the USA will also offer a variety of interactive features to
encourage exploration, such as motion charts with audio tutorials focusing on health costs and outcomes for the developed world. Check out
the site and see what you think.
SOURCES: Jon Gertner, “The Rise and Fall of the G.D.P.” New York Times, 10 May 2010; and The State of the USA site at http://www.stateoftheusa.org/.
QUESTION
1. Is The State of the USA designed to replace GDP as the primary measure of economic performance?
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Case Study 6.2: Price Check on Aisle 2
The U.S. economy is one of the most dynamic in the world, marked by rapid technological change. The Bureau of Labor Statistics (BLS), the
government agency that calculates the CPI each month, employs dozens of economists to analyze the impact of any quality changes to prod-
ucts in the CPI market basket. Each month 400 data collectors visit stores to record about 85,000 prices for 211 item categories in the CPI
basket. About a week before the CPI is released, the BLS offi ce is locked down with bright red “restricted area” signs on all the doors. A total of
90 people, including product specialists and the other economists working on the CPI, compute the basic indexes in each category. Results are
released at 8:30 A.M., Eastern Time, about two weeks after the end of the month in question. This release is a big deal.
Most price adjustments are straightforward. For example, if a candy bar shrinks 10 percent but still sells for the same price, the CPI shows
this as a 10 percent price increase. But sometimes a product changed in a more complicated way. Economists at BLS specialize in particular
products, such as televisions, automobiles, kitchen appliances, and so on. One of their greatest challenges is to identify substitutes for products
that are no longer available on the market. For example, data collectors fi nd the model of TV they priced the previous month is missing about
one-fi fth of the time. When a particular product is missing, a four-page checklist of features such as screen size and the type of remote control
guides the data collector to the nearest comparable model. That price is reported and the product specialist in Washington must then decide
whether it’s an acceptable substitute.
For example, the TV specialist decided that the newer version of the 27-inch model had some important improvements, including a fl at
screen. A complex computer model estimated that the improvements alone would be valued by consumers as worth $135 more. After factoring
improvements into the price of the $330 set, the analyst determined that the price of the TV had actually declined 29 percent [= 135/(330 +
135)]. In another example, the price of a 57-inch TV dropped from $2,239 to $1,910, for an apparent decline of 15 percent. But on closer
inspection, the analyst found that the new model lacked an HDTV tuner that had been included in the model it replaced. This tuner would be
valued by consumers at $514. So, instead of declining 15 percent, the price of the 57-inch TV actually rose 11 percent [= 1,910/(2,239 – 514)].
The TV analyst is applying the hedonic method, which breaks down the item under consideration into its characteristics, and then estimates
the dollar value of each characteristic. This is a way of capturing the impact of a change in product quality on any price change. Otherwise,
price changes would not refl ect the fact that consumers are getting more or less for their money as product features change over time.
SOURCES: Jon Hilsenrath, “A Deeper Look at the Fed’s Infl ation Debate,” Wall Street Journal, 5 April 2010; Javier Hernandez, “Prices of Consumer Goods Hold Steady, Indicating
That Infl ation Is at Bay,” New York Times, 18 March 2010; and Mary Kokoski, Keith Waehrer, and Patricia Rosaklis, “Using Hedonic Methods for Quality Adjustment in the CPI,” U.S.
Bureau of Labor Statistics Working Paper (2000) found at http://www.bls.gov/cpi/cpiaudio.htm.
QUESTION
1. What is the hedonic method and why is it sometimes used to track changes in the consumer price index?
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