Economics 102

Answers to Practice Questions 1

Spring 2001

Answer Key:

I. Refer to the textbook.

II.

1. F. Since the slope of the PPF represents opportunity cost, a linear PPF therefore has a constant opportunity cost.

2. T.

3. F. Only if you specify that y represents monitor and x represents TV.

4. F. No information about how other factors change. Consider, for example, a greater rise of income or prices of other soft drinks. If this price refers to relative price as in the study of economics, then it is true by the law of demand.

5. T.

6. F. Only when the price floor is higher than the equilibrium price.

7. T.

8. T.

9. F. Scarcity means that not all wants can be satisfied, which is true for everyone.

10. F. We cannot even say she has an absolute advantage without information about whether they use the same amount of resources.

11. T. Note that the opportunity costs of economic growth is reduced current consumption.

12. F. The PPF shows the maximum amounts that can be produced.

13. T. With specialization and trade according to the comparative advantage, both counties can consume at levels beyond their PPF's.

14. T.

15. F. Minimum price instead of maximum price.

16. T. As a result, the demand curve shifts to the right and the supply curve shifts to the left (why?), play with the graph, and you will see that the current price will unambiguously rise.

17. F. Price in our model refers to relative price instead of monetary price.

18. F. The law of increasing opportunity cost tells us that the opportunity costs rise as we want more of the good.

19. F. See textbook page 36.

20. F. Recession is a situation in which an economy operates inside its PPF—a slowdown in overall economic activity.

III. Short Answer Problems.

1.

a. First we should convert the numbers using the same time unit:

Australia New Zealand

Steel (tons) 20 per year 4 per year

Coal (tons) 10 per year 8 per year

b. Australia has absolute advantage in the production of both products. To produce one unit of steel or coal, it uses less resources (time): 1/20<1/4 and 1/10<1/8. Or more directly, with the same amount of resources, it produces more of steel or coal.

c. To see the comparative advantage, we calculate their opportunity cost of producing steel and coal first.

Australia New Zealand

OC of producing steel 1/2 2

(in terms of coal)

OC of producing coal 2 1/2

(in terms of steel)

So Australia has a lower opportunity cost of producing steel, it has a comparative advantage in the production of steel; and similarly, New Zealand has a comparative advantage in the production of coal.

d. From the above problem, Australia will specialize in the production of steel and New Zealand will specialize in the production of coal, and both will benefit from the trade.

e. For Australia, its PPF will be a line with slope –2 and intercept 20 on the y-axis. For New Zealand, its PPF will be a line with slope –1/2 and intercept 4 on the y-axis. (The PPF is linear here because of the assumption that the opportunity costs are constant.)

Australia New Zealand

Steel (ton) 20 per year 4 per year

Coal (tons) 10 per year 12 per year

OC of producing steel 1/2 3

(in terms of coal)

OC of producing coal 2 1/3

(in terms of steel)

Australia has an absolute advantage in the production of steel, while New Zealand has an absolute advantage in the production of coal.

Australia has a lower opportunity cost of producing steel, it has a comparative advantage in the production of steel; and similarly, New Zealand has a comparative advantage in the production of coal.

Australia will specialize in the production of steel and New Zealand will specialize in the production of coal, and both will benefit from the trade.

The PPF for Australia doesn’t change, while the PPF for New Zealand is now a line with slope –1/3 and intercept 4 on the y-axis.

2. The demand and supply for bananas in the US are:

Qd = 10 - Pd

Qs = 2Ps -2

a. The equilibrium price and quantity are:

Pe=4, Qe=6

b. This tax results in a movement along the supply curve and a movement along the demand curve because it is in effect a change of price for the good concerned here.

The new prices facing consumers and producers can be computed this way:

(10-Q)-(Q+2)/2=3/2

Solve for the equation, we get:

Q=5

Plug into the demand function, we get Pd=5

Plug into the supply function, we get Ps=7/2

c. Calculate the change in consumer surplus, producer surplus and the dead-weight loss.

Old CS: (10-4)*6/2=$18

New CS: (10-5)*5/2=$12.5

Change in CS: 18-12.5=$5.5

Old PS: (4-1)*6/2=$9

New PS: (7/2-1)*5/2=$6.25

Change in PS: 9-25/4=$2.75

Dead-weight loss: 3/2*(6-5)/2=$.75

Tax Revenue: 3/2*5=$7.5

Notice: old CS + old PS = $27

New CS + new CS + dead-weight loss + tax revenue = $27 (why?)

d. Suppose now the government restrict the quantity of bananas traded to 4 units, plug into the demand and supply functions respectively and get the prices faced by the consumers and producers:

Pd=6, Ps=3

This means the government should impose a tax of $3/banana on the consumption of bananas.

3. The market for radios is described by the demand and supply functions:

Qd = 50 - 2Pd

Qs= 11 + Ps

a. The equilibrium price and quantity are:

Pe=13, Qe=24

b. Suppose the government sets a price ceiling of $11, it will result in a shortage of 6 units of radios:

Qd-Qs=50-2*11-(11+11) = 6

c. Now with the invention of the CD players, the demand for radios is cut to half as much at all prices. Under this situation, the demand curve shifts to the left, and the new demand is:

Qd=25-Pd

With the unchanged supply function, we get:

Pe=7, Qe=18

The price ceiling policy is not effective anymore.