CUFE - Exercise answer

1. Explain each of the following statements using supply-and-demand diagrams for goods mention in each part of the question.

a. When a cold snap hits Florida, the price of orange juice rises in supermarkets throughout the United States. (Orange trees are cultivated in the state of Florida)

b. When the weather turns warm in New England every summer, the price of hotel rooms in Caribbean resorts plummets.

c. When a war breaks out in the Middle East, the price of gasoline rises, and the price of a used car e.g., a Cadillac falls

Suggested answer:

a. Cold weather damages the orange crop, reducing the supply of oranges. This can be seen in Figure 6 as a shift to the left in the supply curve for oranges. The new equilibrium price is higher than the old equilibrium price.

b. People often travel to the Caribbean from New England to escape cold weather, so the demand for Caribbean hotel rooms is high in the winter. In the summer, fewer people travel to the Caribbean, because northern climes are more pleasant. The result, as shown in the figure, is a shift to the left in the demand curve. The equilibrium price of Caribbean hotel rooms is thus lower in the summer than in the winter, as the figure shows.

c. When a war breaks out in the Middle East, many markets are affected. Because a large proportion of oil production takes place there, the war disrupts oil supplies, shifting the supply curve for gasoline to the left, as shown in the figure on the left. The result is a rise in the equilibrium price of gasoline. With a higher price for gasoline, the cost of operating a gas guzzling automobile like a Cadillac will increase. As a result, the demand for used Cadillacs will decline, as people in the market for cars will not find Cadillacs as attractive. In addition, some people who already own Cadillacs will try to sell them. The result is that the demand curve for used Cadillacs shifts to the left, while the supply curve shifts to the right, as shown in the figure on the right. The result is a decline in the equilibrium price of used Cadillacs.

2. The New York Times reported (17 Feb 1996, p.25) that the subway/train ridership declined after a fare increase: “There were nearly 4 million fewer rides in December 1995, the first full month after the price of a token increased 25 cents to $1.50, than in the previous December, a 4.3% decline.”

a. Use these data to estimate the price elasticity of demand for subway rides.

b. According to your estimate, what happens to the Transit Authority’s revenue when the fare rises?

c. Why might your estimate of the elasticity be unreliable?

Suggested answer:

a. If quantity demanded falls by 4.3% when price rises by 20%, the price elasticity of demand is 4.3/20 = 0.215, which is fairly inelastic.

b. Because the demand is inelastic, the Transit Authority's revenue rises when the fare rises.

c. The elasticity estimate might be unreliable because it is only the first month after the fare increase. As time goes by, people may switch to other means of transportation in response to the price increase. So the elasticity may be larger in the long run than it is in the short run.

2. The cost of producing stereo systems has fallen over the past several decades. Let’s consider some implications of this fact.

a. Draw a demand-and-supply diagram to show the effect of falling production costs on the price and quantity of stereos sold.

b. In your diagram, show what happens to consumer surplus and producer surplus.

c. Suppose the supply of stereos is very elastic. Who benefits most from falling production costs – consumers or producers of stereos?

Suggested answer:

a. The effect of falling production costs in the market for stereos results in a shift to the right in the supply curve, as shown in the figure below. As a result, the equilibrium price of stereos declines and the equilibrium quantity increases.

b. The decline in the price of stereos increases consumer surplus from area A to A + B + C + D, an increase in the amount B + C + D. Prior to the shift in supply, producer surplus was areas B + E (the area above the supply curve and below the price). After the shift in supply, producer surplus is areas E + F + G. So producer surplus changes by the amount F + G – B, which may be positive or negative. The increase in quantity increases producer surplus, while the decline in the price reduces producer surplus. Because consumer surplus rises by B + C + D and producer surplus rises by F + G – B, total surplus rises by C + D + F + G.

c. If the supply of stereos is very elastic, then the shift of the supply curve benefits consumers most. To take the most dramatic case, suppose the supply curve were

horizontal, as shown in Figure 12. Then there is no producer surplus at all. Consumers capture all the benefits of falling production costs, with consumer surplus rising from area A to area A + B.

1. Four roommates are planning to spend the weekend in their hostel room watching old movies, and they are debating how many to watch. Their willingness to pay for each movie is:

First Movie Second Movie Third Movie Fourth Movie Fifth Movie Sharon $7 $6 $5 $4 $3 Ai Beng $5 $4 $3 $2 $1 Hui Shin $3 $2 $1 $0 $0 Yee Hui $2 $1 $0 $0 $0

a. Within the hostel room, is the showing of a movie a public good? Why or why not?

b. If it costs $8 to rent a movie video, how many videos should the roommates rent to maximize total surplus?

c. If they choose the optimal number from part (b) and then split the cost of renting the videos equally, how much surplus does each person obtain from watching the movies?

Suggested answer:

a. Within the hostel room, the showing of a movie is a public good. None of the roommates can be excluded from viewing the movie. Because one roommate’s viewing does not affect the ability of another roommate to view the movie, the good is also non-rival in consumption.

b. The roommates should rent three movies because the value of the fourth film ($6) would be less than the cost ($8).

c. The total cost would be $8 × 3 = $24. If the cost were divided evenly among the roommates, each would pay $6. Sharon values three movies at $18 so her surplus would be $12. Ai Beng values three movies at $12 so her surplus would be $6. Hui Shin values three movies at $6, so her surplus would be $0. Yee Hui values three movies at $3 so her surplus is -$3. Total surplus among the four roommates would be $15.

Surplus Sharon $12 Ai Beng $6 Hui Shin $0 Yee Hui -$3

1. Healthy Harry’s Juice Bar has the following cost schedules:

Q(cups) Variable Cost ($) Total Cost ($) 0 0 30 1 10 40 2 25 55 3 45 75 4 70 100 5 100 130 6 135 165

a. Calculate average variable cost, average total cost and marginal cost for each quantity.

b. Graph all three curves. What is the relationship between the marginal cost curve and the average total cost curve? What is the relationship between the marginal cost curve and the average variable cost curve? Explain.

Suggested answer:

a. The following table shows average variable cost (AVC), average total cost (ATC), and marginal cost (MC) for each quantity.

b. The figure below shows the three curves. The marginal-cost curve is below the average-total cost curve when output is less than four and average total cost is declining. The marginal-cost curve is above the average-total-cost curve when output is above four and average total cost is rising. The marginal-cost curve lies above the

average-variable-cost curve.

1. What components of GDP

(if any) would each of the following transactions affect? Explain.

(a) Your neighbour buys a new refrigerator. (b) Your uncle buys a new house.

(c) The government hires teachers to provide free education to the people. (d) Your parents buy a bottle of French wine

(e) A Switzerland Drugs Company set up a lab in Singapore for testing drugs

Suggested answer: 1. a. Consumption increases because a refrigerator is a good purchased by a

household.

b. Investment increases because a house is an investment good. c. Government purchases increase because the government spent money to provide

a good to the public.

d. Consumption increases because the bottle is a good purchased by a household,

but net exports decrease because the bottle was imported.

e. Investment increases because new structures and equipment were built.

2. Below are some data from an economy: Year 2005 2006 Price per football Quantity footballs $10 14 200 200 of Price baseball $8 $10 per Quantity baseballs 75 75 of 2007 14 350 $10 125 (a) Compute nominal GDP, real GDP, and the GDP deflator for each year, suing 2005 as the base year.

(b) Compute the percentage change in nominal GDP, real GDP, and the GDP deflator in 2006 and 2007 from the preceding year. For each year, identify the variable that does not change. Explain in words why your answer makes sense.

(c) Did economic well-being rise more in 2006 or 2007? Explain.

Suggested answer:

2. a. Calculating nominal GDP: 2005: ($10 per football ? 200 footballs) + ($8 per baseball ? 75 baseballs) =

$2,600 2006: ($14 per football ? 200 footballs) + ($10 per baseball ? 75 baseballs) =

$3,550

2007: ($14 per football ? 350 footballs) + ($10 per baseball ? 125 baseballs) =

$6,150

Calculating real GDP (base year 2005): 2005: ($10 per football ? 200 footballs) + ($8 per baseball ? 75 baseballs) =

$2,600 2006: ($10 per football ? 200 footballs) + ($8 per baseball ? 75 baseballs) =

$2,600 2007: ($10 per football ? 350 footballs) + ($8 per baseball ? 125 baseballs) =

$4,500

Calculating the GDP deflator: 2005: ($200/$200) ? 100 = 100 2006: ($3,550/$2,600) ? 100 = 137 2007: ($6,150/$4,500) ? 100 = 137

b.

Calculating the percentage change in nominal GDP: Percentage change in nominal GDP in 2006 = [($3,550 ? $2,600)/$2,600] ? 100

= 37%. Percentage change in nominal GDP in 2007 = [($6,150 ? $3,550)/$3,550] ? 100

= 73%.

Calculating the percentage change in real GDP: Percentage change in real GDP in 2006 = [($2,600 ? $2,600)/$2,600] ? 100 =

0%.

Percentage change in real GDP in 2007 = [($4,500 ? $2,600)/$2,600] ? 100 =

73%.

Calculating the percentage change in GDP deflator: Percentage change in the GDP deflator in 2006 = [(137 ? 100)/100] ? 100 =

37%.

Percentage change in the GDP deflator in 2007 = [(137 ? 137)/137] ? 100 = 0%.

Prices did not change from 2006 to 2007. Thus, the percentage change in the GDP deflator is zero. Likewise, output levels did not change from 2005 to 2006. This means that the percentage change in real GDP is zero.

c.

Economic well-being rose more in 2007 than in 2006, since real GDP rose in 2007 but not in 2006. In 2007, real GDP rose but prices did not. In 2006, real GDP did not rise but prices did.

2.

From 1950 to 2000, manufacturing employment as a percentage of total employment in the U.S. economy fell from 28 percent to 13 percent. At the same time, manufacturing output experienced slightly more rapid growth than the overall economy.

What do these facts say about growth in labour productivity (defined as output per worker) in manufacturing?

In your opinion, should policymakers be concerned about the decline in the share of manufacturing employment? Explain.

(a) (b)

Suggested answer: 2. a. If output is rising and the number of workers is declining, then output per worker

must be rising.

b. Policymakers should not be concerned as long as output in the manufacturing

sector is not declining. The reduction in manufacturing jobs will allow labor resources to move to other industries, increasing total output in the economy. An increase in productivity of workers (as measured by output per worker) is beneficial to the economy.

4. Are the following workers more likely to experience short-term, or long-term,

unemployment? Explain.

(a) A construction worker laid off because of bad weather

(b) A manufacturing worker loses her job at a plant in an isolated area.

(c) A short-order cook loses her job when a new restaurant opens across the street. (d) An expert welder with little education loses his job when the company installs automatic

welding machinery.

Suggested answer: 4. a. A construction worker who is laid off because of bad weather is likely to

experience short-term unemployment, because the worker will be back to work as soon as the weather clears up.

b. A manufacturing worker who loses her job at a plant in an isolated area is likely

to experience long-term unemployment, because there are probably few other employment opportunities in the area. She may need to move somewhere else to find a suitable job, which means she will be out of work for some time.

c. A short-order cook who loses his job when a new restaurant opens is likely to

find another job fairly quickly, perhaps even at the new restaurant, and thus will probably have only a short spell of unemployment.

d. An expert welder with little education who loses her job when the company

installs automatic welding machinery is likely to be without a job for a long time, because she lacks the technological skills to keep up with the latest equipment. To remain in the welding industry, she may need to go back to school and learn the newest techniques.

1. Suppose GDP is $10 million, taxes are $2 million, private saving is $0.7 million, and

public saving is -$0.1 million. Assuming this economy is closed, calculate consumption, government purchases, national saving, and investment.

Suggested answer: 1. Given that Y = 10, T = 2, Sprivate = 0.7 = Y ?T ? C, Spublic = -0.1 = T ? G. Because Sprivate = Y ? T ? C, then rearranging gives C = Y ? T ? Sprivate = 10 ? 2 ? 0.7 =

7.3.

Because Spublic = T ? G, then rearranging gives G = T ? Spublic = 2 ? (-0.1) = 2.1. Because S = national saving = Sprivate + Spublic = 0.7 + (-0.1) = 0.6. Finally, because I = investment = S, I = 0.6.

2. Suppose the government borrows $20 billion more next year than this year.

(a) Use a supply-and –demand diagram to analyze this policy. Does the interest

rate rise or fall?

(b) What happens to investment? To private saving? To public saving? To

national saving? Compare the size of the changes to the $20 billion of extra government borrowing.

(c) Suppose household believe that greater government borrowing today implies

higher taxes to pay off the government debt in the future. What does this belief do to private saving and the supply of loanable funds today? Does it increase or decrease the effects you discussed in parts (a) and (b)?

Suggested answer:

2.

a.

The above figure illustrates the effect of the $20 billion increase in government borrowing. Initially, the supply of loanable funds is curve S1, the equilibrium real interest rate is i1, and the quantity of loanable funds is L1. The increase in government borrowing by $20 billion reduces the supply of loanable funds at each interest rate by $20 billion, so the new supply curve, S2, is shown by a shift

to the left of S1 by exactly $20 billion. As a result of the shift, the new equilibrium real interest rate is i2. The interest rate has increased as a result of the increase in government borrowing.

b.

Because the interest rate has increased, investment and national saving decline and private saving increases. The increase in government borrowing reduces public saving. From the figure above you can see that total loanable funds (and thus both investment and national saving) decline by less than $20 billion, while public saving declines by $20 billion and private saving rises by less than $20 billion.

If households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future, then people will save more so they can pay the higher future taxes. Thus, private saving will increase, as will the supply of loanable funds. This will offset the reduction in public saving, thus reducing the amount by which the equilibrium quantity of investment and national saving decline, and reducing the amount that the interest rate rises. If the rise in private saving was exactly equal to the increase in government borrowing, there would be no shift in the national saving curve, so investment, national saving, and the interest rate would all be unchanged. This is the case of Ricardian equivalence.

3.

c.

The Bureau of Labour Statistics announced that in January 2006, of all adult Americans, 141,481,000 were employed, 4,209,000 were unemployed, and 78, 463,000 were not in the labour force. Use this information to calculate: (a) (b) (c) (d)

The adult population The labour force

The labour-force participation rate The unemployment rate

Suggested answer: 3. The labor force consists of the number of employed (141,481,000) plus the number of

unemployed (4,209,000), which equals 145,690,000.

To find the labor-force participation rate, we need to know the size of the adult population. Adding the labor force (145,690,000) to the number of people not in the labor force (78,463,000) gives the adult population of 224,153,000. The labor-force participation rate is the labor force (145,690,000) divided by the adult population (224,153,000) times

100%, which equals 65%.

The unemployment rate is the number of unemployed (4,209,000) divided by the labor force (145,690,000) times 100%, which equals 2.9%.

Answer

3. You are the curator of a museum. The museum is running short of funds, so you decide to increase revenue. Should you increase or decrease the price of admission? Explain.

Suggested answer:

In order to determine whether you should raise or lower the price of admissions, you need to know if the demand is elastic or inelastic. If demand is elastic, a decline in the price of admissions will increase total revenue. If demand is inelastic, an increase in the price of admissions will cause total revenue to rise.

2. There are four consumers willing to pay the following amounts for haircuts: Jerry: $7 Oprah: $2 Ellen: $8 Phil: $5

There are four haircutting businesses with the following costs: Firm A: $3 Firm B: $6 Firm C: $4 Firm D: $2

Each firm has the capacity to produce only one haircut. For efficiency, how many haircuts should be given? Which businesses should cit hair and which consumers should have their hair cut? How large is the maximum possible surplus?

Suggested answer:

Supply equals demand at a quantity of three haircuts and a price between $4 and $5. The figure below shows the demand and supply functions. Firms A, C, and D should cut the hair of Ellen, Jerry, and Phil. Oprah’s willingness to pay is too low and firm B’s costs are too high, so they do not participate. The maximum total surplus is the area between the demand and supply curves, which totals $11 ($8 value minus $2 cost for the first haircut, plus $7 value minus $3 cost for the second, plus $5 value minus $4 cost for the third).

3. Consider the market for rubber bands.

a. If this market has very elastic supply and very inelastic demand, how would the burden of a tax on rubber bands be shared between consumers and producers? Use the tools of consumer surplus and producer surplus in your answer.

b. If this market has very inelastic supply and very elastic demand, how would the burden of a tax on rubber bands be shared between consumers and producers? Contrast your answer with your answer to part (a).

Suggested answer:

a. With very elastic supply and very inelastic demand, the burden of the tax on rubber bands will be borne largely by buyers. As the figure below shows, consumer surplus declines considerably, by area A + B, but producer surplus does not fall much at all, just by area C + D.

b. With very inelastic supply and very elastic demand, the burden of the tax on rubber bands will be borne largely by sellers. As the figure below shows, consumer surplus does not decline much, just by area A + B, while producer surplus falls substantially, by area C + D. Compared to part (a), producers bear much more of the burden of the tax, and consumers bear much less.

4. Anglers who use nets to catch tuna also sometimes net dolphins which, because they are mammals, drown before they can be released. Currently, the price and quantity of tuna determined by the market does not take into account the cost to society of killing the dolphins (marginal external cost). Listed below are market demand and supply schedules for tuna as well as the marginal external costs associated with dolphins killed in the process of catching tuna. All costs and values are listed in terms of dollars per pound of tuna.

Quantity of tuna Consumer’s marginal willingness to pay 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 Marginal private cost of tuna 2.75 3.00 3.25 3.50 3.75 4.00 5.50 5.70 Marginal external cost of dolphins 2.05 2.15 2.25 2.35 2.45 2.55 2.65 2.75 1000 2000 3000 4000 5000 6000 7000 8000

a. What should be the amount of tax per pound of tuna in order to obtain the socially optimal output? Explain your answer with an appropriate diagram.

b. Of the tax per pound of tuna in (a), how much is the tax burden of consumers and producers? Explain your answer.

Suggested answer:

a.

$ per pound of tuna. MSC

MPC

5.50 4.00 Marginal willingness to pay Quantity of tuna 3000 6000

The socially optimal level of output is 3000 where MSC (= sum of Marginal Private Cost and Marginal External Cost) equals Marginal Willingness to Pay. At this social optimum, the marginal external cost of dolphins is $2.25. So, the tax rate should be equal to $2.25.

[ Graphs of MSC, MPC and MPB that show discrete values are acceptable. ]

b. In the free market, consumers pay $4.00. When the tax is imposed, the price increases to $5.50. Consumers end up paying $1.50 of the tax. Hence, consumers’ tax burden is $1.50*3000 = $4500 and producers’ tax burden is $0.75* 3000 = $2250.

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