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Department of Economics
University of California, Berkeley
Problem Set #1
Fall 2016
Economics 1
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PROBLEM SET #1 Suggested Solutions
1. (3 points total; 1 point each) Supply and Demand
For each of the events described below, sketch a supply and demand graph that illustrates the event. Be sure to properly
label all curves and relevant points in your graph. In the area to the left of your graph, explain why you think your graph is
correct. In that area, also answer the questions asked.
a.
Gasoline: Fracking, a technological development that allows low cost oil extraction from large parts of the United
States, leads to large increases in U.S. production of oil, a key input in the production of gasoline. What is the effect on the
price of gasoline? On the quantity of gasoline sold?
For all supply/demand questions like this, we assume that all other things – aside from what is specified in the question – stay
the same (that is, we make the “ceteris paribus” assumption). Do not add events to the question that are not there. Assume all
other factors are held constant.
The question asks about the supply and demand for gasoline.
Step 1: draw the initial equilibrium (E1) at
P1 and Q1.
Step 2: How do we capture the event?
This event is a change in supply due to
decreased cost of a key input, oil. (The
cost of oil falls because the technological
development – fracking – allows for
increased production, which would be
shown as a shift to the right of the supply
curve in the oil market, which we are not
drawing here.) The increase in supply of
gasoline means at every possible price,
there is an increased quantity of gasoline
available for sale. The entire supply curve
shifts to the right.
Step 3: What is the effect on price and
quantity? The shift to the right of supply
(that is, an increase in the quantity supplied at every possible price), results in a decrease in the price and an increase in the
quantity sold at equilibrium.
Here is a recent article about the effect of fracking on the markets for oil and gasoline:
http://energyindepth.org/national/thank-fracking-for-lower-gas-prices-this-memorial-day-weekend/ . Also, a recent Planet
Money podcast looked at the oil market: http://www.npr.org/sections/money/2016/08/17/490375230/oil-3-how-frackingchanged-the-world
b. Car Maintenance and Repairs: Decreased price of gas leads to more driving. What is the effect on the price of car
maintenance and repair? On the quantity of car maintenance and repair sold?
For all supply/demand questions like this, we assume that all other things – aside from what is specified in the question – stay
the same (that is, we make the “ceteris paribus” assumption). Do not add events to the question that are not there. Assume all
Department of Economics
University of California, Berkeley
Problem Set #1
Fall 2016
Economics 1
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other factors are held constant.
The question asks about the supply and demand for car maintenance and repair.
Step 1: draw the initial equilibrium (E1) at
P1 and Q1.
Step 2: How do we capture the event? Car
maintenance and repairs are a complement
to driving, which is itself a complement to
gasoline. A lower price of gasoline leads to
an increase in the demand for driving,
resulting in more miles being driven. More
miles driven leads to an increase in the
demand for car maintenance and repair.
This is an increase in demand: at every
possible price of car maintenance & repairs,
there is an increased quantity of car
maintenance demanded. The entire
demand curve shifts to the right.
Step 3: What is the effect on price and
quantity? The shift to the right of demand
(an increase in the quantity demanded at
every possible price), results in an increase in price and an increase in the quantity sold.
Here’s an article from 2015 about the effect of lower gas prices on car repair shops:
https://www.automotivemanagementnetwork.com/low-gas-prices-and-auto-repair/
c.
Apartments in San Francisco: Tech busses drastically lower the cost of commuting from SF to the Silicon Valley. At
the same time, AirBnB leads thousands of landlords to convert SF apartments from long-term to short term vacation
rentals. What is the effect on the price of a SF apartment rented to residents? On the quantity of SF apartments rented to
residents?
The question asks about the
supply and demand of
apartments in San Francisco for
residents of SF.
Step 1: draw the initial
equilibrium (E1) at P1 and Q1.
Step 2: How do we capture the
event? There are two events
specified. Let’s take them one at
a time.
The first event: tech busses
reduce the cost of commuting
from SF to the Silicon Valley.
Commuting is a complement to
Department of Economics
University of California, Berkeley
Problem Set #1
Fall 2016
Economics 1
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apartment living. Decreased price on a complement (commuting) increases demand for the good (apartment living). This event
causes an increase in the demand
for SF apartments. At every
possible price, there are more SF
apartments demanded because
of the fall in the price of a
complement. When there is an
increase in demand, the demand
curve shifts to the right.
The second event: AirBnB leads
thousands of landlords to convert
SF apartments from long-term to
short-term vacation rentals. This
event is a change in supply due a
change in the price of a substitute
in production, the increased price
a landlord can easily obtain for a
few nights rental to a tourist. The
decrease in supply of SF
apartments for long-term rentals
means at every possible price,
there is a decreased quantity of
apartments available for rent to
residents. The entire supply curve shifts to the left.
Step 3: What is the effect on price and quantity? The shift to the right of demand (an increase in the quantity demanded at
every possible price), results in an increase in price and an increase in the quantity sold. The shift to the left of supply (that is, an
decrease in the quantity supplied at every possible price), results in an increase in the price and a decrease in the quantity sold
at equilibrium.
Both events lead to an increase in
the price, so we know the effect
on price: it will increase.
But there are opposing effects on
quantity. The change in demand
due to tech busses puts upward
pressure on quantity but the
decrease in supply due to AirBnB
puts downward pressure on
quantity. What is the net effect
on quantity? It depends. (You’ll
find “it depends” is often the
answer in economics. It’s never a
sufficient answer, though. We
need to know on what “it
depends.”)
The net effect on quantity
depends on which shift is larger:
Department of Economics
University of California, Berkeley
Problem Set #1
Fall 2016
Economics 1
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the increase in demand or the decrease in supply. If you drew the shifts the same size, then you had no effect on quantity. If
you shifted demand more than you shifted supply, quantity Q2 is more than quantity Q1. If you shifted supply more than you
shifted demand, Q2 is less than Q1.
The graphs illustrate why this is the case. The demand curve shifts to the right and the supply curve shifts to the left changing
the equilibrium point from E1 to E2. In all cases, equilibrium price increases from P1 to P2. The effect on quantity depends
upon which curve shifts more: neither (quantity unchanged), demand (quantity rises), or supply (quantity falls).
For recent news articles related to this question, see http://www.sfchronicle.com/business/item/Window-into-Airbnb-s-hiddenimpact-on-S-F-30110.php and article #12 in your reader.
2.
(2 points total, ½ point each) Production Possibilities Frontier, Aid, Trade
a.
A relatively poor country with wide, beautiful beaches bordering warm ocean water can produce two goods: tourism
and agricultural products (food, cotton, etc.). Let’s call it Beautiful Island, BI. In recent years, the finance minister of the
country has advocated construction of more and more tourist hotels. But economic advisors from an NGO advise instead
that the country focus on increasing its agricultural productivity through crop rotation, use of fertilizer, and other methods.
Use the Production Possibilities Frontier model and the axes at right to illustrate this debate. Put “tourism” on the vertical
axis and “agricultural products” on the horizontal axis. Select some point to illustrate where the economy is now. What
changes does the finance minister want to see? What changes do the NGO advisors want to see? Explain your answers.
The initial PPF should be a
standard downward-sloping, nonlinear PPF such as shown at right
as PPF1.
The finance minister wants to
construct more tourist hotels. That
would represent an increase in
capital that increases the total
amount of tourism that can be
produced if all resources are used
to produce tourism, but has no
impact on the amount of
agricultural products that could be
produced if all resources were used
to produce agricultural products.
Therefore the finance minister is
advocating asymmetric growth.
The end point on the tourism axis
increases, but there is no effect on
the end point on the agricultural
output axis. This is shown as PPF2
in the graph at the right.
The NGO advisors want an increase in agricultural productivity. Again this will result in asymmetric growth, but this time with
an increase along the agricultural output axis and no change in the total amount of tourism that could be produced if all
resources were devoted to agricultural production. The effect is PPF3 shown in the graph above.
Department of Economics
University of California, Berkeley
Problem Set #1
Fall 2016
Economics 1
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b. This beautiful beachfront country (BI) establishes a trade relationship with a wealthy nearby land-locked not-at-allbeautiful country (let’s call it Ugly Mainland, UM). The land-locked country (UM) produces agricultural products and does
so at a lower opportunity cost than does the beachfront country (BI). Assuming transportation costs are relatively low,
how will production and consumption in the beautiful beachfront country (BI) change? Explain.
Because the land-locked country (UM) has a lower opportunity cost of producing agricultural output than does the beautiful
island (BI), the UM will produce agricultural goods and BI will produce tourism, and the two countries will trade. Residents of
UM will travel to the beautiful island, stay in the beachfront bungalows, sip drinks with little umbrellas in them, and generally
consume lots of tourism. That is, BI will export tourism to UM. On the other hand, residents of UM will produce agricultural
products and will sell those goods to residents of BI. BI will export food and other agricultural outputs to UM.
Together the two countries will produce more tourism and more agricultural output than could be produced if each was trying
to be self-sufficient. Production in BI will shift primarily to the production of tourism with very little if any production of
agricultural output, but the residents of BI (and of UM) will consume a combination of tourism and agricultural output that falls
beyond its PPF. There will be gains from trade.
c.
After trade relations had begun, a large tsunami struck the beachfront country (BI) and destroyed over half of the
tourist hotels. How will this affect BI’s PPF? What will happen to BI’s production? To its opportunity costs of producing
food? Will BI continue to trade with UM? Discuss.
The tsunami destroys capital
that had been used to produce
tourism, a decrease in the
quantity of resources available.
This is shown as a shift inward in
the PPF.
Whether you showed this as
symmetric or asymmetric change
depends upon what assumptions
you made. If you assumed the
tsunami destroyed tourist hotels
but had no impact on land for
agricultural output in BI, then you
would have a shift down along
the vertical axis but no change
along the agricultural output
axis. If instead you assumed the
tsunami destroyed tourist hotels
and also destroyed the ability of
land to grow agricultural output,
then you would show a shift
inward along both axes.
If the tsunami affected only tourist hotels (a reasonable assumption, given the prompt), then in BI the opportunity cost of
producing food is now lower than it was before the tsunami. There will be less tourism given up when BI switches resources
from tourism to agricultural output. Trading with the UM for agricultural output may no longer be the economically rational
thing to do! Instead, the beautiful island may want to see its workers shift from tourism (now difficult to produce because of
the loss of hotels) to producing agricultural output.
Department of Economics
University of California, Berkeley
Problem Set #1
Fall 2016
Economics 1
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d. Using the PPF, explain why the provision of international aid to rebuild the tourist hotels boosts the economy of BI
more than would be the case if BI was responsible for repairing its own tourist facilities.
The comparison here is between
the resources for rebuilding the
hotels [1] coming from the BI
economy as opposed to [2] being
provided through international
aid. If international aid provides
the resources for rebuilding tourist
hotels, then BI can use more of its
own resources for producing food.
In the graph at right, BI uses
resources to produce tourism
output equal to 50 units.
International aid provides
resources – not money but labor
and capital and knowledge – to
rebuild hotels, which increases
tourism output by another 30
units. The total tourism output in
BI is thus the sum, 50 units
produced with BI’s own resources
and 30 units produced with
international aid resources.
Because BI is producing only 50 units of tourism with its own resources, it is able to allocate its remaining resources to the
production of agricultural output, allowing BI to produce 300 units of agricultural output. If BI had been required to use its own
resources to produce the additional 30 units of tourism output, the agricultural output would have been only about 180 units of
agricultural output, point CA on the graph above.
It’s important to remember that resources do not include money. Giving money to BI in the wake of the tsunami would not
increase its land, its (physical) capital, its labor force, or its knowledge. To increase the amount of production, resources – not
money – are needed. “Boots on the ground.” Lumber, concrete, steel, hammers, nails, equipment. Engineers with knowledge of
how to produce more efficiently so as to combine the existing capital and labor and land and produce more output.
3. (1 points total, ½ point each) Positive versus Normative Economic Analysis
For each statement below, is it an example of positive or normative economic analysis (circle the answer in the box).
Defend.
a.
A decrease in the estate tax should worsen wealth and income inequality.
Positive
Or
Normative
This is a positive economic statement. One thing (a decrease in the estate tax) causes the other (rising wealth & income
inequality). It is the result of employing an economic model – that is an answer to a question – of the factors that determine
wealth & income inequality, and analyzing how one of those factors, taxes, affects inequality. Note that “should” is not a clue
as to whether a statement is positive or normative.
Department of Economics
University of California, Berkeley
Problem Set #1
b.
A decrease in the estate tax should be beneficial for the U.S. economy.
Fall 2016
Economics 1
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Positive
Or
Normative
This is a normative statement. This is a statement about whether a policy is “good” or “bad” (in this case, beneficial = good).
But it does not tell us what goal is being used to evaluate the policy. What is “beneficial” for the economy is not defined, and is
subject to interpretation. There are a number of different definitions of “beneficial,” each equally valid, with no one agreed
upon definition. Does beneficial mean “increase equality”? Does beneficial mean “increase economic growth”? Does beneficial
mean “reduce the government budget deficit”? Does beneficial mean “reduce taxes paid by individuals”?
4. (1 point total) Counterfactual
Each statement below is a commonly-heard but wrong way to assess policy. Write a new sentence that properly evaluates
the policy.
a.
The number of health insurance companies operating in Texas is lower now than it was before implementation of the
Affordable Care Act.
The problem with this sentence is it is comparing yesterday with today instead of comparing today with what today would
have been in the absence of the policy. One proper evaluation would be: “The number of health insurance companies
operating in Texas today is lower than it would have been today had the Affordable Care Act not been implemented.” This
revised statement compares today with ACA (reality) and today without ACA (hypothetical), which thus controls for everything
other than ACA. It is an example of “ceteris paribus” – holding all else (other than ACA) constant.
For an article that examines the availability of health insurance in 2016, see http://kff.org/health-reform/issue-brief/analysisof-insurer-participation-in-2016-marketplaces/
b. Britain’s economic growth will be slower following its exit from the European Union (Brexit) than it was before the
exit.
This sentence suffers from the same problem: the sentence compares yesterday and today, not today with and without the
policy. One proper evaluation would be “Britain’s economic growth in 2017 will be slower following its exit from the EU than it
would have been in 2017 had Britain remained in the EU.” (Any year is fine.) The revised statement compares economic
growth in Britain in a specific time period (reality) with what the growth would have been in that same time period had Brexit
not passed.
There are literally hundreds of articles about the (predicted) effect of Brexit. Here’s a recent one from The Economist:
http://www.economist.com/news/britain/21702225-forget-financial-markets-evidence-mounting-real-economy-suffering. And
here’s an article interviewing Berkeley economist Barry Eichengreen http://www.fuw.ch/article/the-british-economy-after-thereferendum/ . If you’re interested in international financial economics, you definitely want to follow Prof. Eichengreen on
Twitter. https://twitter.com/B_Eichengreen
5.
(3 points total) Economic Growth.
Choose any country and any time period, current or historical. Write a one-page essay in which you address these
questions:
•
What is one development in that country that enhanced economic growth?
•
In general, how did that development enhance growth?
•
If you were a policy maker responsible for enhancing growth today in an extremely poor country such as Malawi or
Burundi, would you recommend adoption of the development you discussed above? Why or why not?
Department of Economics
University of California, Berkeley
Problem Set #1
Fall 2016
Economics 1
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Of course, there are lots of specific examples, so we can’t provide you with “this is what you should have written.”
Guidelines:
a. Did you follow the specifications? One-page essay? Max of 400 words? 1” margins? Double-spaced? 10 or 11 or 12 pt
font? Your name and date & word count in the top right corner? Your essay stapled at the back of your problem set? Attached
your “works cited” list (either at the end of page 1 or on a separate page)? Submitted both via bCourses & in hard copy?
If so, you remained eligible for full credit. If not, you lost a point right off the top.
b.
Did you choose an example from a country in some time period? If so, good! Then you should have been able to discuss
one development in that country that enhanced economic growth. The idea here is to integrate what you have learned in other
courses (history, civics, anthropology, and so on) into what you are learning in economics.
Economic growth is enhanced by either an increase in the quantity of inputs or an increase in productivity. The end of Chapter 5
of Macro as a Second Language lists a lot of institutional changes that can enhance economic growth.
For instance, if you chose the United States, you could have mentioned the Louisiana Purchase (a huge increase in the quantity
th
of land), or any of several immigration reforms after 1965 (increases in labor), or the spread of computers in the late 20
century (a big increase in physical capital). Or you could have focused on an institutional change that enhanced productivity
th
and therefore contributed to economic growth: the rise of public education in the first half of the 20 century (raising
educational attainment dramatically in just a few decades) or the Morrill Land Grant Act of 1862 (establishing public
universities around the country); development of patent laws (which encourage innovation); establishment of a national
currency as part of the Banking Acts of the 1860s (a development in financial institutions that made trade easier); or the
Federal Aid Highway Act of 1956 (establishing the interstate highway system, which lowers transportation costs markedly); or
the writing and adoption of the U.S. Constitution (which ensures that political power passes smoothly from one leader to the
next, with no risk that debts incurred by one President’s Administration will not be honored by a subsequent administration,
lowering borrowing costs); or the system of Free and Common Socage (which defines our property rights system, granting an
individual right of waste and alienation, and freedom from willy-nilly government levies, encouraging improvement in
property); or the establishment of an independent judiciary (which enforces contracts not based on who pays the judges more
but based on the principles of law).
Your paper could have used any country, any time period, and any example – so long as it was real and so long as you chose
something that enhanced growth either through an increase in quantity of inputs or an increase in productivity.
c.
Did you explain how that development enhanced economic growth?
You needed to link your example either to an increase in the quantity of inputs or an increase in productivity. From there,
economic theory says we expect to see an increase in economic growth.
d.
Did you discuss whether or not that same example would help a really poor country today?
Here you wanted to think about whether the example you came up with was specific to your country or time. Were there
prerequisites in place that enabled that development to enhance growth? Are those prerequisites in place in an extremely poor
country today?
For instance, “they should lower interest rates because that will increase spending for physical capital” is a bit of advice that
presumes a well-functioning financial system. Or “they should establish public universities using federally owned land” is a bit
of advice that presumes a reasonable share of the population is ready for university education.