Download Exam 2 Review Problems (Hints and Answers)

Exam 2 Review Problems (Hints and Answers)
ECNS 204
1.) Mutt and Jeff find themselves on a deserted island. The only two activities available are
fishing and hunting rabbits. In a full day, Mutt can catch 6 rabbits or 10 fish; in the same time,
Jeff can catch 6 rabbits or 3 fish. Activities can be divided with no loss of efficiency. When left
to their own devices, Mutt consumes 3 rabbits and 5 fish, and Jeff consumes 2 rabbits and 2 fish.
Explain how Mutt and Jeff can improve their standard of living through specialization. If they
decide to continue to consume their original amount of fish each, what are their gains from
specialization and trade? What role, if any, does one person’s absolute advantage play in your
analysis?
First we must solve for the MCs of production:
For Mutt:
MC of 1 rabbit = 5/3 fish
MC of 1 fish = 3/5 of a rabbit
For Jeff:
MC of 1 rabbit = ½ fish
MC of 1 fish = 2 rabbits
So, we see that Mutt is the low cost producer (i.e. has a comparative advantage) in catching fish
and Jeff is the low cost producer in hunting rabbits. When they specialize Mutt will only fish
and Jeff will only hunt. In doing so, the bundle of goods produced in the economy is (10 fish, 6
rabbits). Without specialization we were told that Mutt catches 3 rabbits and 5 fish while Jeff
catches 2 rabbits and 2 fish. So, via specialization we see that the gains are 3 fish and 1 rabbit.
Absolute advantage plays no role in this analysis.
2.) In China, the wages are about 20 cents per hour. (In the US, the average wage is about
$20/hour). It seems like China could produce virtually everything cheaper than could America,
and yet China imports various goods from the U.S., such as office machines. Why do they do
this?
They do this because they have a comparative advantage in some products, while the U.S. has a
comparative advantage in other products (e.g. office machines). Through specialization and
trade both can be made better off.
3.) The U.S. government maintains price supports on both corn and wheat, i.e., the government
maintains a price for each of these grains above what would otherwise exist with a free market.
a.) Explain, with a diagram, why we have surpluses in these grains.
Simply two standard supply and demand graphs for corn and wheat where a price support is
shown in both markets. There is a surplus for each good because Qs > Qd.
b.) Suppose the price floor for corn was abandoned, so there was a free market for corn,
but the price support was maintained for wheat. Explain the effects of this on the markets for
corn and wheat.
When the price floor for corn is abandoned, the market price for corn will fall to the market
clearing equilibrium. Given these two goods are likely substitutes, this will have an impact on
the wheat market. In particular, the demand for wheat will decrease (as shown by a shift in the
demand curve). But, because the price floor still exists in the wheat market, the price stays the
same. The quantity of wheat demanded decreases and the surplus gets bigger.
4.) Suppose the state of Washington decided to increase the sales tax on fast food restaurants,
e.g. McDonalds.
The standard sales tax graph from class and your text should be used when answering this
question.
a.) Provide an estimate for the elasticity of demand for fast food restaurants, and justify
your answer.
You could go either way on this as long as you justify your answer. Do you think
substitutes for fast food exist?
b.) How will the increased tax affect the total amount consumers in this state spend on all
the fast food restaurant meals they purchase?
Your answer will depend upon your estimate of the elasticity of demand. If you think
demand is inelastic, then TEs will go up.
c.) Who will likely pay the bulk of the sales tax, consumers or restaurant owners? Be
sure to use a diagram to justify your answer.
Again, this depends on your estimate of the elasticity of demand. If demand is inelastic,
then sellers are able to pass the majority of the tax onto consumers.
5.) Assume that peanut butter and jelly are compliments. Also, suppose that the government
maintains a price floor in the market for peanut butter and the market for jelly is unrestricted.
Now, suppose that the government gets rid of the price floor for peanut butter. What happens to
the price of jelly?
You need to support your answer with diagrams for both markets.
When the price floor is abandoned, the price of peanut butter will fall to the market clearing
level. Because the two goods are compliments, then we know that the demand for jelly will
go up…so, price of jelly increases and so does the quantity exchanged.
6.) Suppose Chuck owns a coal mining firm and his marginal cost schedule (in tons of coal) is
given as follows
Q(tons)
1
2
3
4
5
6
MC
50
100
150
200
250
300
Also, suppose the market price for a ton of coal is $200. How many tons of coal will
Chuck’s firm produce? Graphically illustrate his marginal cost curve and show on your
graph the total costs of production when the market price is $200. How much are the total
costs?
Simply plot the points above to illustrate Chuck’s MC curve (i.e. supply curve).
He will produce up to the point where P = MC…so, he produces 4 tons. The total production
costs are represented by the area under the MC curve up to Q = 4 tons…make sure to
calculate this amount.
7.) Suppose the output of wheat is given by the following production function where L
represents the labor input and TP represents the total product, or output (per day), in bushels.
L
TP
1
10
2
26
3
43
4
51
5
60
6
68
7
74
8
79
9
83
10
86
11
88
Assume a bushel of wheat sells for $10 and this price is unaffected by total output from this
farm. Assume all the laborers can earn $80 per day in their next best alternative.
a.) Suppose the farm is “common property”, i.e. no one owns it, and anyone who wishes can
farm and share equally in the output. Explain why common property leads to a harvest that is
“too large”, i.e. an inefficient (explain what this means) level of production. How many
people will farm in this case?
b.) Suppose the farm is privately held. How many workers would the owner hire, and
would it be an efficient (explain what this means) allocation of resources?
c.) Suppose the TP schedule given above was doubled
L
TP
1
20
2
52
3
86
4
5
6
7
8
9
10
11
102 120 136 148 158 166 172 176
What impact does this have on the level of inefficiency under common property? That is,
is common property more or less inefficient than before?
For a.) and b.) we write the following value columns:
L
VTP
VMP
VAP
1
100
100
100
2
260
160
130
3
430
170
143
4
510
80
127.5
5
600
90
120
6
680
80
113
7
740
60
105.7
8
790
50
98.75
9
830
40
92
10
860
30
86
11
880
20
80
a.) Here, we know that workers will join up to the point where VAP = w. This occurs at L = 11.
This is inefficient because workers #7 through #11 could be producing more elsewhere.
b.) Here, we know that owners will hire workers up to the point where VMP = w. This occurs at
L = 6. This is efficient because workers #1 through #6 could not be reallocated in any manner to
produce more output for society.
c.) If we double the TP the inefficiency under common property will simply worsen. Work
through the numbers to convince yourself of this.