Economics 102

Summer 2012
Answers to Homework #2
Due 7/2/12
Directions: The homework will be collected in a box before the lecture. Please place your name,
TA name and section number on top of the homework (legibly). Make sure you write your name
as it appears on your ! so that you can recei"e the correct grade. Please remember the section
number for the section you are registered because you will need that number when you submit
exams and homework. #ate homework will not be accepted so make plans ahead of time. !"ease
s#ow your work$ $ood luck%
&. 'conoland and (ree 'nterprise are two economies each producing two goods) airplanes
(A) and grains ($). *urrently the two economies do not trade with one another. The table
below pro"ides information about the amount of labor needed to produce one airplane or
one ton of grains for each economy. Assume that labor is the only input needed to
produce either airplanes or grains.
+uantity of #abor ,eeded to
Produce -ne Airplane
+uantity of #abor ,eeded to
Produce -ne Ton of $rains
'conoland &.. hours of labor /. hours of labor
(ree 'nterprise &/. hours of labor &.. hours of labor
(or this 0uestion assume that both economies ha"e linear production possibility frontiers
(PP(). (urthermore, assume that both countries ha"e 1... hours of labor a"ailable for the
production of airplanes and grains.
a. n two separate graphs draw the PP(s for these two economies. n each graph
measure airplanes on the hori2ontal axis and grains on the "ertical axis. Make sure
you label each graph clearly as to whose PP( is represented in the graph. Also label
the numerical "alues of the x and y intercepts in each graph.
Answer)
1
b. 3rite an e0uation in slope intercept form for 'conoland4s PP( and an e0uation in
slope intercept form for (ree 'nterprise4s PP(.
Answer)
'conoland) $ 5 6. 7 8A
(ree 'nterprise) $ 5 1. 7 (198)A
c. 3hat is 'conoland4s opportunity cost of producing one additional airplane:
Answer) 8 tons of grain
d. 3hat is (ree 'nterprise4s opportunity cost of producing one additional ton of grain:
Answer) 891 of an airplane
e. 3hat is 'conoland4s opportunity cost of producing ten additional tons of grain:
Answer) / airplanes. To see this use the e0uation in (b). f 'conoland is initially
producing . tons of grain that means they can produce 1. airplanes. f 'conoland
then produces &. tons of grain then it can only produce 8/ airplanes. The opportunity
cost of producing the &. tons of grain is e0ual to the fi"e airplanes that they must gi"e
up in order to produce the additional &. tons of grain.
f. 3hat is (ree 'nterprise4s opportunity cost of producing four additional airplanes:
Answer) 6 tons of grain. To see this use the e0uation in (b). f (ree 'nterprise is
initially producing . airplanes that means they can produce 1. tons of grain. f (ree
'nterprise then produces ; airplanes then it can only produce 8; tons of grain. The
opportunity cost of producing the ; airplanes is e0ual to the 6 tons of grain that they
must gi"e up in order to produce the additional ; airplanes.
2
<uppose these countries decide to speciali2e and trade with one another.
g. 3hat good should 'conoland produce: 'xplain your answer.
Answer)
'conoland should speciali2e in producing grains since it can produce grains at a
lower opportunity cost than can (ree 'nterprise. (or 'conoland the opportunity cost
of producing one ton of grains is = airplane while for (ree 'nterprise the opportunity
cost of producing one ton of grains is 891 airplane.
h. 3hat good should (ree 'nterprise produce if the two economies speciali2e: 'xplain
your answer.
Answer)
(ree 'nterprise should speciali2e in producing airplanes since it can produce
airplanes at a lower opportunity cost than can 'conoland. (or (ree 'nterprise the
opportunity cost of producing one airplane is 198 tons of grains while for 'conoland
the opportunity cost of producing one airplane is 8 tons of grain.
i. Pro"ide a range of trading prices in terms of tons of grain acceptable to both countries
if &. airplanes are traded.
Answer) f is helpful to think about this as a number line "isually. (ree 'nterprise is
willing to produce one airplane pro"ided it recei"es at least 198 tons of grain.
'conoland is willing to pay 8 tons of grain or less for one airplane. 'xamine the
pro"ided "isual below.
>ut, the 0uestion asks for the range of trading prices for &. airplanes. <o,
3
The acceptable range of trading prices for &. airplanes will be between &/ and 8.
tons of grain.
?. Pro"ide a range of trading prices in terms of airplanes acceptable to both countries if
8/ tons of grain are traded. (,ote) these numbers will be messy.)
Answer)
@se the same reasoning as in part (i). The acceptable range of trading prices for 8/
tons of grain will be between &8./ and /.91 airplanes.
k. !raw a graph of the ?oint PP( of these two economies. Measure airplanes on the
hori2ontal axis and grains on the "ertical axis. Pro"ide numerical "alues for any
intercepts as well as any AkinksB in your PP(.
Answer)
Although this graph looks almost like it4s a linear PP( if you will on close
examination that it is not% <ee the answers to the next part of this 0uestion.
l. 3rite the e0uations for each segment of the PP( you drew in (k). Make sure you
identify the rele"ant range for each e0uation you write.
Answer)
(or airplanes less than or e0ual to 8., the PP( can be written as $ 5 C. 7 (198)A. for
airplanes greater than or e0ual to 8., the PP( can be written as $ 5 &..D 8A. The two
segments do not ha"e the same slope and are therefore not the same line.
8. 'conoland and (ree 'nterprise, the two economies from the first problem are still our
focus. ,othing has changed with these two economies except that 'conoland has trained
4
their labor force and now finds that it takes only /. hours of labor to produce one
airplane. $i"en this information you are asked to answer this next set of 0uestions.
a. 3ho has the comparati"e ad"antage in producing airplanes now:
Answer)
'conoland has the comparati"e ad"antage in producing airplanes now since
'conoland4s opportunity cost of producing one airplane is & ton of grain while (ree
'nterprise4s opportunity cost of producing one airplane is 198 tons of grain.
b. 3ho has the comparati"e ad"antage in producing tons of grain now:
Answer)
(ree 'nterprise has the comparati"e ad"antage in producing tons of grain now since
(ree 'nterprise4s opportunity cost of producing one ton of grain is 891 airplane while
'conoland4s opportunity cost of producing one ton of grain is & airplane.
c. Pro"ide a range of trading prices in terms of tons of grain acceptable to both countries
if &. airplanes are traded.
Answer)
An acceptable range of trading prices for &. airplanes is between &. and &/ tons of
grain.
d. Pro"ide a range of trading prices in terms of airplanes acceptable to both countries if
8/ tons of grain are traded.
Answer)
An acceptable range of trading prices for 8/ tons of grain is between /.91 airplanes
and 8/ airplanes.
e. !raw the new ?oint PP( of these two economies. Measure airplanes on the hori2ontal
axis and grains on the "ertical axis. Pro"ide numerical "alues for any intercepts as
well as any AkinksB in your PP(.
Answer)
5
f. 3rite the e0uations for each segment of the PP( you drew in (k). Make sure you
identify the rele"ant range for each e0uation you write.
Answer)
(or airplane production less than or e0ual to 6. airplanes, the PP( can be written as $
5 C. 7 A. (or airplane production greater than or e0ual to 6. airplanes, the PP( can
be written as $ 5 &8. 7 (198)A.
1. !raw a diagram for each of the following scenarios and then make a "erbal statement
about the effect of the described changes on the market. n your description make sure
you discuss shifts and the direction of these shifts, mo"ements, changes in the
e0uilibrium price, and changes in the e0uilibrium 0uantity.
a. The market for bicycles is initially in e0uilibrium. <uppose that the Madison
Transit Authority imposes a mandatory usage fee to all bicyclists in Madison.
Answer)
The usage fee is effecti"ely a complementary good to bicycles. 3hen the usage
fee increases this causes the 0uantity demanded of the complementary good to
decrease at e"ery price) the demand cur"e for bicycles shifts to the left. This
results in a mo"ement along the supply cur"e and the e0uilibrium price and
0uantity of bicycles decreasing from their initial le"els.
6
b. *onsider the market for petroleum which is initially in e0uilibrium. *i"il unrest
erupts in the Middle 'ast, a ma?or production region for petroleum.
Answer)
*i"il unrest in the Middle 'ast causes the supply cur"e for petroleum to shift to
the left due to the disruption in production. The impact of the pollution tax is to
raise the cost of producing petroleum products for producers of these products)
the supply cur"e will also shift to the left due to this change. The shift in supply
causes a mo"ement along the demand cur"e) the e0uilibrium price for petroleum
will increase and the e0uilibrium 0uantity of petroleum will decrease relati"e to
their initial le"els.
7
c. *onsider the le"el of aggregate production in an economy. The economy is
initially in e0uilibrium and then, due to a financial bubble, the demand for goods
and ser"ices in this economy decreases at e"ery price le"el. At the same time
go"ernment reacts to consumer pressure to reduce go"ernment spending on goods
and ser"ices.
Answer)
!ue to the financial bubble there is a decrease in the demand for goods and
ser"ices at e"ery price le"el) this implies that the demand for all goods and
ser"ices as measured in the aggregate is going to decrease or, in other words, that
the demand for aggregate production in this economy will shift to the left. At the
same time if the go"ernment also reduces its demand for goods and ser"ices this
will cause an e"en greater shift to the left of the demand for aggregate production
cur"e in this economy. These shifts will cause a mo"ement along the aggregate
supply cur"e. Eelati"e to the initial le"el we can expect both the aggregate
production le"el in the economy as well as the aggregate price le"el in the
economy to fall.
8
d. *onsider the market for brownies which is initially in e0uilibrium. <uppose that
the price of chocolate, a ma?or ingredient in brownies, increases while
simultaneously the price of milk, a complementary good to brownies, decreases.
Answer)
The supply cur"e for brownies will shift to the left due to the increase in the price
of chocolate since chocolate is an input in the production of brownies. The
demand for brownies will shift to the right due to the decrease in the price of the
complementary good, milk. The result of these two shifts is that the e0uilibrium
price of brownies will increase relati"e to its initial le"el while the e0uilibrium
0uantity is indeterminate. That is, the e0uilibrium 0uantity may increase,
decrease, or remain the same as the initial e0uilibrium 0uantity.
9
;. *onsider the small closed economy of <mith"ille. <mith"ille produces birdhouses and the
domestic demand and domestic supply cur"es for birdhouses in <mith"ille are gi"en
below.
!omestic !emand for birdhouses) + 5 &. 7 P
!omestic <upply for birdhouses) + 5 P 7 8
The world price of birdhouses is F;.
a. *alculate the "alue of consumer surplus (*<), producer surplus (P<), and total
surplus (T<) in the market for birdhouses if <mith"ille is a closed economy.
Answer)
*< 5 (&98)(F&. per birdhouse D F6 per birdhouse)(; birdhouses) 5 FG
P< 5 (&98)(F6 per birdhouse D F8 per birdhouse)(; birdhouses) 5 FG
T< 5 *< H P< 5 F&6
b. *alculate the "alue of consumer surplus (*<open), producer surplus (P<open),
and total surplus (T<open) in the market for birdhouses if <mith"ille is an open
economy.
Answer)
*<open 5 (&98)(F&. per birdhouse D F; per birdhouse)(6 birdhouses) 5 F&G
P<open 5 (&98)(F; per birdhouse D F8 per birdhouse)(6 birdhouses) 5 F8
T<open 5 *<open H P<open 5 F8.
c. f <mith"ille is an open economy how many birdhouses will <mith"ille export or
import:
10
Answer)
At a world price of F;, the 0uantity of birdhouses domestically demanded in
<mith"ille is e0ual to 6 birdhouses. At a world price of F;, the 0uantity of
birdhouses domestically supplied in <mith"ille is e0ual to 8 birdhouses. The
number of birdhouses imported is e0ual to the 0uantity demanded domestically
minus the 0uantity supplied domestically, or ; birdhouses will be imported.
d. <uppose <mith"ille opens its economy to trade but imposes a tariff of F& per
birdhouse. Iow many birdhouses will <mith"ille import or export gi"en this
scenario:
Answer)
A tariff of F& per birdhouse will increase the price of birdhouses from F; per
birdhouse to F/ per birdhouse. At a price of F/, the 0uantity of birdhouses
demanded domestically will e0ual / while the 0uantity of birdhouses supplied
domestically will e0ual 1. The number of birdhouses imported when there is a F&
tariff per birdhouse is e0ual to 8 birdhouses.
e. *alculate the "alue of consumer surplus with the tariff (*<tariff), producer
surplus with the tariff (P<tariff), tariff re"enue for the go"ernment, and
deadweight loss due to the tariff (!3#tariff).
Answer)
*<tariff 5 (&98)(F&. per birdhouse D F/ per birdhouse)(/ birdhouses) 5 F&8./.
P<tariff 5 (&98)(F/ per birdhouse D F8 per birdhouse)(1 birdhouses) 5 F;./.
Tariff Ee"enue for the go"ernment 5 (F& per birdhouse)(8 birdhouses) 5 F8
!3#tariff 5 (&98)(F/ per birdhouse D F; per birdhouse)(1 birdhouses 7 8
birdhouses) H (&98)(F/ per birdhouse D F; per birdhouse)(6 birdhouses 7 /
birdhouses) 5 F&
,ote that the sum of *<tariff H P<tariff H Tariff Ee"enue H !3#tariff is e0ual to
the sum of T<open you found in (b).
f. Eelati"e to open trade, will this tariff be politically supported by consumers in
<mith"ille: 'xplain your answer.
Answer)
,o, consumers will not support this tariff since they are better off when there is
no tariff but an open economy. ,otice that with an open economy they get the
good for a lower price, they get more of the good, and their *< is e0ual to F&G.
3ith the tariff they pay a higher price, get less of the good, and their *< is smaller
since it is e0ual to F&8./. with the tariff.
g. s opening the market for birdhouses to trade in <mith"ille a good policy mo"e:
!iscuss your answer.
11
Answer)
Jes, ha"ing an open economy here increases total surplus from F&6 to
F8..Iowe"er, opening this market to trade does ha"e distributional conse0uences)
domestic consumers benefit from the market opening to trade while domestic
producers are hurt when the market is open to trade.
/. *onsider the small closed economy of <mith"ille. <mith"ille produces birdhouses and the
domestic demand and domestic supply cur"es for birdhouses in <mith"ille are gi"en
below.
!omestic !emand for birdhouses) + 5 &. 7 P
!omestic <upply for birdhouses) + 5 P 7 8
The world price of birdhouses is F;. -fficials in <mith"ille ha"e decided to open the
birdhouse market to trade while imposing an import 0uota of 1 units. (Iere a unit of
birdhouses might be a box of hundreds of birdhousesKdon4t worry if you get a fraction
of a unit as your answer%)
a. 3hat will be the price of birdhouses in <mith"ille with this import 0uota:
Answer)
3ith the 0uota we know that the 0uantity supplied domestically plus the 0uota
must e0ual the 0uantity demanded domestically. 3e can write this as
+s H 0uota 5 +d
>ut, we know that +s 5 P 7 8 and +d 5 &. 7 P. (urthermore we know that the
0uota is 1 units. <o,
P 7 8 H 1 5 &. 7 P
8P 5 C
P0uota 5 F;./.
b. 3hat will be the total 0uantity of birdhouses demanded in <mith"ille with this
import 0uota:
Answer)
@se the demand e0uation to find out how many birdhouses will be demanded if
the price is F;./.. 3e ha"e +d 5 &. 7 ;./ 5 /./ birdhouses.
c. Iow many birdhouses will domestic producers in <mith"ille pro"ide to this
market:
Answer)
@se the supply e0uation to find out how many birdhouses will be supplied by
domestic producers if the price is F;./.. 3e ha"e +s 5 ;./ 7 8 5 8./. ,ote that if
you add the 1 birdhouses that are the import 0uota to +s you get +d.
d. 3hat is the deadweight loss due to this import 0uota:
Answer)
12
!3#import0uota5 (&98)(;./ 7 ;)(8./ 7 8) H (&98)(;./ 7 ;)(6 7 /./)
!3#import0uota 5 F.8/
e. f the go"ernment officials in <mith"ille wanted to implement a 0uota that had the
same impact on consumer and producer surplus as a tariff of F&, how big would
the import 0uota need to be: (Iint) if you think about this logically you will not
need to do any mathDpro"ided you answered 0uestion L; in its entirety%)
Answer)
(rom problem ; we saw that when the go"ernment implements a tariff of F& per
birdhouse this resulted in imports of 1 birdhouses. <o, an import 0uota of 1
birdhouses would ha"e the same impact on *< and P< as a tariff of F& per
birdhouse.
6. <uppose that the market for widgets is described by the following demand and supply
cur"es)
!emand) P 5 8. 7 8+d
<upply) P 5 8+s
a. 3hat is the e0uilibrium price and 0uantity gi"en this information:
Answer)
@se the two e0uations that are gi"en to find the e0uilibrium.
8. 7 8+e 5 8+e
;+e 5 8.
+e 5 /
Pe 5 &.
<uppose the go"ernment decides to limit the production of widgets in this economy by
imposing a 0uantity control of 8 units.
b. Iow much will it cost producers to purchase a permit allowing them to produce the
good:
Answer)
<uppliers are willing to supply 8 units when the price is e0ual to F; (use the supply
cur"e to get this price suppliers must get to be willing to supply 8 units). !emanders
must pay F&6 per unit in order to limit their demand to 8 units. This suggests that
there is a wedge of F&8 between the price consumers must pay and the price that
suppliers must recei"e in order for 8 units to be pro"ided in this market. The permit
will cost F&8 per widget.
c. $i"en the 0uantity control, what will the "alue of consumer surplus be:
Answer)
*onsumer surplus will e0ual (&98)(F8. per widget D F&6 per widget)(8widgets) 5 F;
13
d. $i"en the 0uantity control, what will the "alue of producer surplus be:
Answer)
Producer surplus will e0ual (&98)(F; per widget D F. per widget)(8 widgets) 5 F;
e. $i"en the 0uantity control, what will be the go"ernment re"enue from issuing and
selling permits to produce widgets:
Answer)
$o"ernment re"enue from the 0uantity control 5 (F&8 per widget)(8 widgets) 5 F8;
f. $i"en the 0uantity control, what will the deadweight loss from this program be:
Answer)
!3# from the 0uantity control 5 (&98)(F&6 per widget D F; per widget)(/ widgets 7 8
widgets) 5 F&G
g. !oes the sum of go"ernment re"enue from the 0uantity control H producer surplus
from the 0uantity control H consumer surplus from the 0uantity control H deadweight
loss from the 0uantity control e0ual total surplus prior to the imposition of this
program by the go"ernment:
Answer)
Jes, in both cases these two sums e0ual F/..
14