Principles of Economics W1105.

002

Spring 2012

Prof. Musatti

Problem Set 1 - Solutions

Please dont forget that: A If you want more feedback on your homework, please visit Prof. Musatti and the TAs during office hours. B. Unless the grading TA has clearly omitted to mark part of your work, no grade challenges.

1. Yes. If you want to take advantage of the free tickets, you have to incur transportation costs to and from the movie theatre and use about a couple of hours of your time. 2. a. A person, firm or nation has an absolute advantage in the production of an item if, using the same amount of resources, it can produce more of that item than another person, firm or nation. Freedonia has an absolute advantage in the production of fruit and in the production of timber. b. A person, firm or nation has a comparative advantage in the production of an item if it can produce that item at a lower opportunity cost than another person, firm or nation. In Sylvania, the opportunity cost of one board feet of timber is 10/5 = 2 baskets of fruit. In Freedonia, the opportunity cost of one board feet of timber is 30/10 = 3 baskets of fruit. Sylvania has a comparative advantage in the production of timber; Freedonia has a comparative advantage in the production of fruit. c. Baskets of Fruit Sylvanias PPF Baskets of Fruit 36,000 Freedonias PPF

12,000

6,000

Board Feet of Timber

12,000

Board Feet of Timber

d. In Sylvania, workers are twice as effective in the production of fruit as in the production of timber. In order to produce an equal amount of fruit as timber, in the timber industry twice as many workers (800) must be employed as in the fruit industry (400). In Freedonia, workers are three times as effective in the production of fruit as in the production of timber. In order to produce an equal amount of fruit as timber, in the timber industry three times as many workers (900) must be employed as in the fruit industry (300). e. If Sylvania specialized in the production of timber and traded timber for fruit with Freedonia at a rate between 2 baskets per board feet and three baskets for board feet, both nations would be better off. For example, Sylvanias production of timber could increase from 4,000 board feet to 6,000 board feet and 1,800 board feet of timber could be exchanged at a rate of 2.5 baskets of fruit per board foot for a total of 4,200 baskets of fruit. Domestic production of fruit would have to fall from 4,000 baskets to no basket at all, but consumption of fruit would all the same increase to 4,200 baskets while consumption of timber would also increase to 6,000 1,800 = 4,200 board feet. In Freedonia, production of fruit could increase by 4,500 baskets reducing production of timber by 1,500 board feet. As the nation would be importing 1,800 board feet of timber and exporting 4,200 baskets of fruit, in Freedonia, consumption of timber and fruit would each increase by 300 units. 3. The availability of new energy drinks could reduce the demand for Red Bull, as some consumers would shift from Red Bull to the new close substitutes. However, if the intense advertising of the new drinks increased the total size of the market, Red Bull would be left with a smaller share of a larger market. In this case, the entry of the new energy drinks would hardly reduce demand for Red Bull or would raise it. 4. Solved in class.