Practice Problem Answers

PRACTICE PROBLEM ANSWERS:

Use the following table to answer the following questions Q Marginal Benefit Marginal Cost 1 40.00 20.00 2 25.00 20.00 3 15.00 20.00 4 10.00 20.00 5 0.00 20.00 a.) The table above represents the marginal benefits and marginal costs associated with playing rounds of golf in a month. How many rounds of golf will this person play? He’ll play as long as the marginal benefit is greater than the marginal cost, which true for the first 2 rounds (so Q=2). b.) If there was a membership cost of $50 to join this golf club, how many rounds will this person play? The membership cost is a sunk cost, so it has no bearing on how many rounds he will play. So the answer is still Q=2. (Note: Sunk costs never matter. It wouldn’t have changed if the membership was $100 or $0. All that matter are marginal costs/marginal benefits. ) c.) If marginal costs increased to $26.00 per round, how many rounds would he play? If the marginal costs increased to $26.00, he would only play 1 round.

2. In order to discourage people from engaging in an activity, one should decrease the benefits and increase the costs associated with that activity.

3) Describe what the opportunity cost of working on this study guide is to you. It’s the net benefits you would have received from (or the amount you value) your next best alternative (what you forego by working on this study guide).

4) A person is choosing between 3 activities, all of which don’t involve any explicit costs. A offers $20 in benefits, B offers $15 in benefits, and C offers $10 in benefits. Which activity will this person choose and what is the opportunity cost associated with that activity. This person will choose Option A, and the opportunity cost is $15 (the net benefits they would have received from their next best alternative).

5) According to the principle of comparative advantage, everyone does best by specializing in whatever they have a lower opportunity cost of doing, regardless of their absolute advantages.

6) Use the following production possibilities frontier to answer question 6. ipods

300 700 850 laptops The figure above represents the production possibility frontier for ipods and laptops for Apple. a.) What is the opportunity cost of increasing the production of ipods from 800 to 1000? 400 laptops. b.) What about the opportunity cost of increasing the production of laptops from 300 to 700? 200 ipods. c.) What happens to the opportunity cost as we devote more and more resources to the production of either good? They’re increasing

A 30 X

The graph above represents Tom’s PPC for two activities, X and Y. 7a.) The opportunity cost to Tom of doing 1 X is 3 Y. 7b.) The opportunity cost to Tom of doing 1 Y is 1/3 X. 7c.) Point A on the graph above equals 10.

8) Use the following table to answer the following questions: Joe Ken Wheat 50 tons/year 10 tons/year Rice 25 tons/year 100 tons/year

8b.) Who has a comparative advantage in what? Joe has a C.A. in wheat production because he has a lower opportunity costs to producing wheat. Therefore, Ken has a C.A. in rice production 8c.) How long will it take them in total to produce 200 tons of wheat and 200 tons of rice if they each produce 100 tons of each? It will take the Joe 2 years to produce 100 tons of wheat, 4 years to produce 100 tons of rice. It will take the Ken 10 years to produce 100 tons of wheat, 1 year to produce 100 tons of rice.

8d.) How long will it take them in total to produce 200 tons of wheat and 200 tons of rice if they only do what they have a comparative advantage in? It will take the Joe 4 years to produce 200 tons of wheat, Ken 2 years to produce 200 tons of rice. Important thing here is the most efficient way to produce the two goods is to specialize in what they have a comparative advantage in. 9) Suppose the opportunity cost to the U.S. of producing 1 X is 20 Y. The opportunity cost to Mexico of producing 1 X is 15 Y. a) Who has an absolute advantage in task X and who has an absolute advantage in task Y? Absolute advantages are indeterminate in this case, because we don’t know how much each country can produce of both X and Y. b) Who has a comparative advantage in task X and who has a comparative advantage in task Y? Mexico has the comparative advantage in task X because they have the lower opportunity cost to doing it. Therefore, the U.S. has the comparative advantage in Y. c) How could we maximize production of both X and Y? Mexico should only produce X, the U.S. should only produce Y, and they should trade with one another.

9.) Use the following demand and supply table to answer the following questions.

Price Q demanded Q supplied $0.25 500 200 $0.50 400 400 $0.75 200 600 $1.00 100 800

9a.) What is the equilibrium price and quantity in the market shown above? P=$.50; Q=400 9b.) If the price is currently $0.75, then there will be an excess supply, the market price will fall, quantity supplied will fall, and quantity demanded will rise.

10) When there is an excess demand (shortage) in a market, what can you predict will happen to the price, quantity supplied, and quantity demanded in that market? Excess demand will cause price to increase, quantity demanded to decrease and quantity supplied to increase until they are equal.

11a) The reservation price to consumers represents their maximum willingness to pay and is based on benefits. 11b.) The reservation price to consumers represents their minimum willingness to sell and is based on costs.

12) An individual will buy a good as long as the price is less than their reservation price? A seller will sell a good as long as the price is greater than their reservation price?

Use the following graph, representing two demand curves to answer question 13: P C

D Q 13a). Refer to the graph above, and assume it represents a normal good. If consumers see their incomes decrease, their likely response will best be represented by which arrow? D (demand is shifting in) 13b.) Refer to the graph above, and assume it represents an inferior good. If the price of the good rises, their likely response will best be represented by which arrow? B (moving upward along the demand; it doesn’t matter whether it’s an inferior good).

14) An increase in “demand” refers to a shifting of the demand curve rightward; an increase in “quantity demanded” refers to a downward movement along a stationary demand curve?

15) Fill in the blanks to indicate how the following changes will affect supply or demand. 15a) An increase in the price of a complement will cause Demand to shift In (left) 15b) A decrease in income will cause Demand to shift Out for an inferior good.; 15c) An improvement in the technology will cause Supply to shift Out (right) 15d) An increase in the price of an input will cause Supply to shift In (left) 15e) An increase in the price of a good will cause ______to shift _____. A change in the price of the good will not cause either supply or demand to shift.

16) The supply of good A is lower than the supply of good B. If the two goods face equal demand curves, which good will have the higher price? If the market price of good B higher than good A, what does this mean as far as demand for the two goods? If they face equal demand curves, the good with the lower supply will have a higher price (A). If the market price of good B is higher, this implies that the demand for good B is higher than for good A.

17) Assume the price of milk increases. What do you expect to happen to the equilibrium price and quantity in the market for cheese (milk is used as an input in the production of cheese)? Milk is an input in the production of cheese, so supply will decrease. This will cause the equilibrium price to increase and quantity to decrease.

18) A decrease in equilibrium price and a decrease in equilibrium quantity could be produced by a(n) decrease in demand, other things constant?

19a.) On a clearly labeled set of axes, illustrate the probable effects of a decrease in the price of cattle feed, to the supply and/or demand for beef. Start with an equilibrium labeled (Po, Qo) and label the new equilibrium (P1, Q1). Explain what changed: Demand or quantity demanded? Supply or quantity supplied? The decrease in P for cattle feed causes supply for beef to shift out (right). Supply changed, and quantity demanded changed. P1Q0; The graph looks as follows: P S S’ S

P 0 P 1

Q Q 0 1 Q 19b.)Assume after the decrease in the price of cattle feed, the price of chicken increases. What is the likely effect to the supply and/or demand for beef, if any? Explain what changed: Demand or quantity demanded? Supply or quantity supplied? Furthermore, if the new equilibrium is (P2, Q2), do you expect P2 and Q2 to be greater than, less than, or indeterminate when compared with P1 and Q1? The increase in the price of chicken causes demand for beef to increase (shift right). Therefore, demand changed, and quantity supplied changed. P2>P1 and Q2>Q1 The graph looks as follows:

P S S’ S

P 2 P 1

D’ D

Q Q 1 2 Q 20) An individual expect to receive $10 in benefits from a good that cost $2 to produce. If the price of the good is $2, what is the amount of consumer and producer surplus associated with this transaction? The consumer surplus is $8 (benefits ($10) – price($2)). The producer surplus is $0 (price ($2) – costs ($2)).

21) Explain why economists prefer the natural market equilibrium to alternatives such as price controls? The market equilibrium maximizes market surplus (net benefits) to market participants (consumers and producers). Government interference (such as price controls) take us away from the natural market equilibrium and result in a reduction in market surplus.

22) Use the following diagram to answer the following questions. P S 100

10 D 500 1000 1500 Q

22a) What is the consumer and producer surplus in the above market associated with the 500th quantity? CS=$80-$50=$30; PS=$50-30=$20. 22b) What would happen if the government set a price ceiling equal to $30? There would be a shortage of 1,000 units. 22c) What would happen if the government set a price ceiling equal to $80? Nothing. The price would be $50.

23) If supply decreases at the same time that demand increases, what do you expect to happen to the equilibrium price and quantity? Price will definitely increase; quantity may rise, fall, or stay the same.

Q Reservation Price of Buyers Reservation Price of Sellers 1 $150.00 $40.00 2 $100.00 $50.00 3 $80.00 $60.00 4 $70.00 $70.00 5 $60.00 $80.00 24a. What is the equilibrium price and quantity in the market shown above? Q*=4; P*=$70.00 24b. If the market is in equilibrium, what is the consumer and producer surplus associated with the first quantity in the market? CS = $150 - $70 = $80. PS = $70 - $40 = $30; 25. Use the following diagram to answer the question below. P S 130

30 D Q 2000 3000 4000 Calculate the total amount of consumer and producer surplus when the market above is in equilibrium. When the market is in equilibrium P*=$80 and Q*=3000. Consumer surplus equals the area below demand, above price. This equals ½ ($130 – $80)*3000=$75,000 Producer surplus equals the area below price, above supply. This equals ½ ($80 – $30)*3000=$75,000.

26) What is the formula for price elasticity of demand?

% change in quantity demanded/% change in price = (change in quantity /original quantity) / (change in price / original price)

27) If demand is price elastic, this means that the percentage change in quantity demanded is greater than compared to the percentage change in price.

28) If the price elasticity of demand equals -2.5, a 3% increase in price will have what effect to quantity demanded? It will cause quantity demanded to decrease by 7.5% (3%*-2.5).

29) The price of TVs decreases from $400 to $300 and quantity demanded increases from 6,000 to 7,000. Calculate the price elasticity of demand for TVs using the basic percentage formula. Are TVs inelastic, elastic or unit-elastic? elasticity=(% change in quantity / % change in price) =(1,000/6,000)/(-$100/$400)=.167/-.25= -0.67 Because it is less than one in absolute value, it is inelastic.

30) Draw a perfectly elastic demand curve and perfectly inelastic demand curve. What does the price elasticity of demand for each equal?

Perfectly elastic demand curves are horizontal and have a price elasticity equal to infinity. Perfectly elastic demand curves are vertical and have a price elasticity equal to zero.

31) Determine whether demand for the following goods are elastic, inelastic, or unit elastic: a.) Price increases by 10% and revenue increases by 10%. INELASTIC. b.) Price increases by $10 and revenue decreases by 12%. ELASTIC. c.) Price increases by 10% and quantity demanded decreases 10 units. INDETERMINATE d.) Price decreases by 10% and revenue doesn’t change. UNIT ELASTIC. e.) Price decreases by 10% and revenue increases from $400 to $500. ELASTIC. f.) Price decreases by 5% and quantity demanded increases by 5% UNIT ELASTIC.

32) A good has a price elasticity equal to -0.6 and quantity demanded is 10,000. What is the new quantity demanded when price decreases by 10%? What will happen to total revenue (will it increase or decrease)? Quantity demanded will increase by -0.6*-10%=6% such that the new quantity demanded will be 10,000 + 10,000*6% = 10,600. Total revenue will decrease because it is inelastic and price decreased.

33) Income increases by 3% and quantity demanded decreases from 100 to 95. What is the income elasticity of demand for this good? Is it a normal or inferior good?

EI = -5% / 3% = -1.666. It’s inferior

34) The cross price elasticity between good B and C is +2, and the price of good C decreases by 6%. What happens to the quantity demanded for good B? Are these goods complements or substitutes? Quantity demanded for good B decreases by 12% (-6%*2). Goods B and C are substitutes.

35) Is the cross-price elasticity positive or negative for the following items? a. tuna and peanut butter. Positive (because they are substitutes). b. beer and pretzels. Negative (because they are complements).

36) Fill in the blank with “positive” or “negative” The income elasticity of demand is positive for a normal good, and negative for an inferior good; the cross price elasticity is negative for complements and positive for substitutes; the price elasticity of supply is positive.

The answer to the first extra credit question is Alvin Roth or Lloyd Shapley.