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Principles of Microeconomics
Spring, 2002
Dr. Kathryn Wilson
Due: Thursday, January 31, 2001
Homework 1
beans
1. John has a garden behind his apartment where he grows beans and cabbage. The following
graph shows his production possibilities frontier.
80
75
70
65
60
55
50
45
40
35
30
25
20
15
10
5
0
0
a.
5 10 15 20 25 30 35 40 45 50
cabbage
i. Give an example of a combination of beans and cabbage that would be efficient for
John to produce.
Any point on the production possibilities frontier (PPF) would be efficient. For
example, 40 cabbage and 25 beans.
ii. Give an example of a combination of beans and cabbage that would be attainable but
inefficient for John to produce.
Any point under the PPF would be attainable (he could produce it) but would not be
efficient (he would not be using his resources to their fullest – he could make more).
For example, 20 cabbage and 25 beans.
iii. Give an example of a combination of beans and cabbage that would be unattainable
for John to produce.
Any point beyond the PPF would not be attainable. For example, 45 cabbage and
25 beans.
b.
i. If John is currently producing 10 cabbage and he decides he wants to produce 15
cabbage instead, what is his opportunity cost of increasing from 10 to 15 cabbage?
To move from 10 cabbage to 15 cabbage, he must go from 70 to 65 beans. He must
give up 5 beans to increase his cabbage. Five beans is the opportunity cost of
moving from 10 to 15 cabbage.
ii. If John is currently producing 35 cabbage and he decides he wants to produce 40
cabbage instead, what is his opportunity cost of increasing from 35 to 40 cabbage?
To move from 35 cabbage to 40 cabbage, he must go from 35 to 25 beans. He must
give up 10 beans to increase his cabbage. Ten beans is the opportunity cost of
moving from 35 to 40 cabbage.
c. Does John have increasing opportunity costs? Explain what increasing opportunity costs are
and how you know either he does or does not have them.
John has increasing opportunity cost. If he is making 10 cabbage, he only has to give up 5
beans to get an extra 5 cabbage (move from 10 to 15 cabbage in part i. above). If he is
making 35 caggabe, he has to give up 10 beans to get an extra 5 cabbage (move from 35 to
40 cabbage in part ii. above). The opportunity cost of getting more cabbage increases the
more cabbage he is producing. The other way we know this is because the PPF is a curve
rather than a straight line. We find the opportunity cost by taking the slope of the PPF;
with a curve, the slope keeps increasing as you move along.
d. In general, what has to be true about resources in order to have increasing opportunity costs?
Give an example of two products that would have a production possibilities frontier with
increasing opportunity costs. (Do not use the example given in class. Rather, make up an
example of your own.)
In order to have increasing opportunity costs, there must be some resources that are
specialized. This means that some resources are better suited for making one product or
another. For example, if you have a garden that is half in the sun and half in the shade, the
sunny side will be better for growing one vegetable while the shade part will be better
suited for growing a different vegetable. The more “sunny” vegetable you try to grow, you
will have to start planting it in the shade where it doesn’t grow well and where the “shady”
vegetable does grow well. You will have to give up a lot of “shady” vegetable to get a little
more “sunny” vegetable.
e. Give two examples of things that would shift John’s production possibilities frontier out (to
the right). Make the examples specific to the growing of beans and cabbage.
Two things that will shift the production possibilities frontier out are an increase in
resources and changes in technology. For an increase in resources, perhaps John gets more
fertilizer or increases the size of his garden. This will increase his ability to produce both
beans and cabbage. For a change in technology, if a new fertilizer were developed that
worked really well this would increase what John could produce.
2. Betty Crocker and Martha Stewart both bake. Betty can bake 6 cakes an hour or 3 batches of
cookies an hour. Martha can bake 4 cakes an hour or 1 batch of cookies an hour. They both
have 5 hours a day to bake.
Martha's PPF
30
30
25
25
20
20
cakes
cakes
Betty's PPF
15
15
10
10
5
5
0
0
0
5
10
15 20
cookies
25
30
0
5
10
15 20
cookies
25
30
a. Draw Betty’s production possibilities frontier on the first graph and Martha’s on the second
graph. (Remember that they bake for 5 hours a day.) See graph. Remember, they have 5
hours a day to bake so this is the PPF for the entire day.
b. What is Betty’s opportunity cost of one more batch of cookies? What is Martha’s opportunity
cost of one more batch of cookies? We find opportunity cost by taking the slope of the PPF.
Betty’s opportunity cost of 1 more batch of cookies = (30-0)  (0-15) = -2. For each batch of
cookies Betty makes, she must give up 2 cakes. Martha’s opportunity cost = (20-0)  (0-5) =
-4. For each batch of cookies Martha makes, she must give up 4 cakes. (Another way of
looking at this is in the time it takes Martha to make a batch of cookies, she could have
made 4 cakes.)
c. Who has an absolute advantage in making cookies? Who has an absolute advantage in
making cakes? Explain in your own words what absolute advantage means.
Betty has the absolute advantage in both cakes and cookies. Absolute advantage means
that given the same resources, you can make more of a product that someone else can.
Betty can make 30 cakes (if all she does is make cakes) while Martha could only make 20;
Betty can make 15 cookies (if all she does is make cookies) while Martha could only make 5.
d. Who has a comparative advantage in making cookies? Who has a comparative advantage in
making cakes? Explain in your own words what comparative advantage means.
To calculate comparative advantage we have to look at opportunity cost. Comparative
advantage means that you can produce a product at a lower opportunity cost than the
other person. The opportunity cost of 1 more batch of cookies is 2 cakes for Betty and 4
cakes for Martha. Betty has a comparative advantage in making cookies (she only gives up
2 cakes while Martha would have to give up 4). If Betty has a comparative advantage in
cookies, then we know that Martha has to have the comparative advantage in cakes (one
person cannot have the comparative advantage in both goods).
e. If Betty and Martha were to specialize and trade, who should make cookies? Who should
make cakes? Since Betty has a comparative advantage in cookies, we want Betty to make
cookies and Martha to make cakes.
f. Give an example of the “terms of trade” – what is the most number of cakes that would be
traded for 1 batch of cookies? What is the least number of cakes that would be traded for 1 batch
of cookies? Betty had to give up 2 cakes to make a batch of cookies (her opportunity cost is
2); therefore, Betty will have to be offered at least 2 cakes for each batch of cookies.
Martha could make a batch of cookies herself by giving up 4 cakes (her opportunity cost is
4); therefore, the most Martha would be willing to trade is 4 cakes for each batch of cookies
(if she had to trade more than 4 cakes, she would be better off making the cookies herself
and not trading). We don’t know exactly how many cakes will be traded for each batch of
cookies, but it will be somewhere between 2 and 4 cakes for each batch.
g. Give an example of a trade that would make both Betty and Martha better off.
There are a lot of trades that will make them both better off. One example is if Betty
trades 5 batches of cookies. Based on the answer to f, we know that if she trades 5 batches
of cookies she could get between 10 and 20 cakes (the terms of trade are 2 to 4 cakes for
each batch of cookies). So 5 batches of cookies for 12 cakes would work (so would 5
batches for 14 cakes or 5 batches for 18 cakes, etc.).
h. Betty can bake faster than Martha. (In fact, Betty has been known to do a bit of trash talking
rubbing this in Martha’s face.) Given this, she is skeptical as to why she should trade with
Martha. She is thinking that she would be better off just baking things herself. Set Betty straight
and explain to her the intuition for why both Betty and Martha can gain from trading with each
other. By focusing on what they have a comparative advantage in making, both parties can
be made better off by trade. The key is that even though Betty has an absolute advantage
in both goods, each hour she spends making cakes is an hour she isn’t spending making
cookies. She can either spend an hour making 6 cakes and in doing so give up the
possibility of making 3 cookies or she can make the 3 cookies and trade them to Martha for
anywhere between 6 and 12 cakes (2 to 4 cakes for each batch of cookies). Clearly she
would rather trade for 12 cakes than bake 6 cakes herself. By focusing on what she has a
comparative advantage in, and then trading with Martha, both Betty and Martha can
move to a point beyond their own PPF.
3. The following are some examples of observations I have made the past few months (some of
them are real and some are embellished). For each example, I want you to use the economic
theory of supply and demand to explain what is happening. Include in your answer whether a
curve (supply or demand or both) shifts, which direction it shifts, why it shifts, and what happens
to price and quantity as a result of the shift.
a. With the introduction of PlayStation II, I noticed the price of the original PlayStation game
console fell. You could either think of this as a change in preference – consumers prefer
PlayStation II to PlayStation, so the demand curve for PlayStation shifts in. Or, you could
think of this as a change in the availability of substitutes; since PlayStation II and
PlayStation are substitutes, as PlayStation II becomes available, the demand curve for
PlayStation shifts in. Either way, the demand curve for PlayStation shifts in resulting in a
lower equilibrium quantity and lower price.
b. Because there were more employment layoffs this fall (people losing their jobs), retailers did
not expect people to purchase as many toys for Christmas as last year. (As a side note, see if you
can think of any toys that might actually have higher sales because of more employment layoffs;
what do we call these goods?) The high number of layoffs results in a reduction of income
for consumers. If toys are a normal good (which most are), then when people’s income
falls, the demand curve for toys shifts in. The result is a lower quantity of toys being sold
and a lower price for toys. Toys that are “inferior goods” may increase sales. These may
include low-price toys that people buy more of because they can’t afford to buy the higher
price nice toys.
c. Because of an announcement I heard on the news that OPEC is going to cut back the
production of oil, I decide to go out tonight and buy gas for my car even though I would
normally wait until my tank is on empty.
If OPEC is cutting back oil production, I expect the price of gas to get higher in the future.
Since I expect the price of gas to get higher, I will choose to buy more gas today at the
current price. This means that my demand curve for gas has shifted out – even though the
price of gas today hasn’t changed I am willing to buy more gas today. The result is the
current price of gas will go up (since demand shifted out) and the quantity of gas sold will
increase.
d. New discoveries make it much cheaper to produce the batteries used in electric cars. As a
result, two things happen: the price of electric cars falls and the price of traditional cars falls. In
your answer, try to explain both phenomenons. (Note: the new discoveries do not affect the
production of traditional cars – only electric cars.)
If it is cheaper to produce electric cars, the supply curve for electric cars will shift out (the
price of an input in production has gone down). This results in a higher quantity of electric
cars being sold at a lower price. Since electric cars and traditional cars are substitutes,
when the price of electric cars goes down, people substitute towards electric cars and away
from traditional cars. This will result in the demand curve for traditional cars shifting in,
giving us a lower price of traditional cars and a lower quantity being sold.
e. A draught really hurts the potato crop. As a result, fewer french fries are sold at fast food
restaurants. The draught results in the supply curve for potatoes shifting in, which increases
the price of potatoes. Since potatoes are an input in the production of french fries, the
supply curve for french fries shifts in. The price of french fries goes up and fewer french
fries are sold. Notice that the demand curve for french fries doesn’t shift, just the supply.