Eco 201 Name_______________________________ Test 1 Key 17 June 2005 100 points. Explain all answers. Please write answers in ink. Good Luck. Allocate your time efficiently. 1. Gomer can make either 200 bushels of corn (C) or 200 bushels of strawberries (S) every six months. Goober can make only 100 bushels of corn (C) or 50 bushels of strawberries (S) every six months. a. Build a table to show their corresponding production possibilities. b. What is Gomer's opportunity cost of making one bushel of corn? c. What is Gomer's opportunity cost of making one bushel of strawberries? d. What is Goober's opportunity cost of making one bushel of corn? e. What is Goober's opportunity cost of making one bushel of strawberries? f. Who has a comparative advantage in making corn? g. Who has a comparative advantage in making strawberries? h. Provide terms of trade between corn and strawberries that would be mutually beneficial to both Gomer and Goober if each specialized and exchanged the product of his comparative advantage. Corn (bu) Strawberries (bu) Opp. Cost of Corn Opp. Cost of Strawberries Gomer 200 200 1 bu strawberries 1 bushel of corn Goober 100 50 ½ bu strawberries 2 bushels of corn (a) The table tells us that Gomer can produce 200 bushels of corn, and zero strawberries or zero corn and 200 bushels of strawberries. Goober can produce 100 bushels of corn and zero strawberries or zero corn and 50 strawberries. (b) one bushel of strawberries. (c) 1 bushel of corn. (d) ½ bushel of strawberries. (e) 2 bushels of corn. (f) Goober. (g) Gomer. Please notice something very important here. Gomer appears “better” at both corn and strawberry production – he can produce a larger quantity of either good, relative to Goober. But the notion of comparative advantage does not simply focus on total output. It focuses on the opportunity cost of producing a particular output. Gomer and Goober have different costs of producing corn and strawberries. We’ve just seen that Goober is more efficient (has a comparative advantage) at producing corn compared to Gomer. Remember that all questions regarding efficiency (and therefore, comparative advantage) require us to look not only at total benefit or output, but at the sacrifices or opportunity costs that an individual must incur to produce that benefit or output. (h) Both Gomer and Goober would gain with any terms of trade in the following range: 1 bushel of strawberries being exchange for more than 1 bushel of corn but less than 2 bushel of corn. For example, 1bushel of strawberries being exchanged for 1½ bushels of corn (1½ is in between 1 and 2). 2. Here's further practice in shifting supply and demand curves. What would happen to the market-clearing price of acoustic guitars if a. People turned on to some accordion craze and started losing interest in learning to play the guitar? b. The price of electric guitars were to fall substantially? c. A number of acoustic guitar makers decide to exit the market and make violins instead? d. The price of the materials used to make guitar cases were to rise substantially?(a) The demand for acoustic guitars would decrease (the curve would shift to the left). That would tend to reduce both the price of acoustic guitars, and the quantity of acoustic guitars exchanged (supplied). (b) Electric guitars are a substitute for acoustic guitars. Some players would switch to electric guitars (the quantity demanded for electric guitars would increase), thereby reducing the overall demand for acoustic guitars. That means the demand curve for acoustic guitars would shift left, reducing both the market-clearing price and the quantity of acoustic guitars exchanged (supplied). (c) This affects the supply curve for acoustic guitars. Fewer suppliers means the supply curve shifts left, and the result is a rise in the market price of acoustic guitars, which causes a decline in the quantity of acoustic guitars exchanged (demanded). [Did the demand for acoustic guitars fall? No, only the quantity demanded.] (d) This affects the supply curve for guitar cases—a complement good for guitars. The price of guitar cases rises, thereby reducing the quantity of guitar cases exchanged. The higher price of guitar cases reduces the demand for guitars, meaning the demand curve shifts left. The result is a decline in the market price of acoustic guitars, which causes a decline in the quantity of acoustic guitars exchanged (supplied). 3a. "If there is a shortage of platinum, its price will rise. The shortage will eventually disappear because the higher price will reduce demand and increase supply." Evaluate this statement. b. If gasoline prices continue above $2.00 a gallon, what would tend to happen to the demand for eight-cylinder SUVs? What would that tend to do to the market price of those SUVs? This is a confused statement. A shortage of platinum means that, at the current price, the quantity supplied is less than the quantity demanded. Competitive market bidding would indeed emerge, but as the price is bid up, neither overall supply nor demand changes. Quantity supplied would increase and quantity demanded would decrease. The two curves don’t shift—neither curve increases nor decreases. We simply move along each of them. Graphically, the price would rise until we reach a point where the two curves intersect. That’s the point where quantity supplied equals quantity demanded. That’s the price that coordinates the plans of buyers and sellers of platinum—what economists call the market-clearing price. People would consider buying vehicles that use less gasoline. The demand for eight-cylinder SUVs likely falls as people begin seeking gas-conserving substitutes. The fall in demand (the curve shifts left) would tend to reduce both the market price of those SUVs and the quantity of SUVs supplied (or exchanged). 4a. What does it cost you to sleep through one of 30 lectures in a course for which you paid $300 in tuition? What does it cost you to attend? b. Do students put more effort into courses when they have to pay higher tuition to take the courses? The cost of sleeping through is the value of the knowledge thereby not acquired. The data on tuition costs are irrelevant because these are not affected by your decision to attend or not attend—nor is your decision to attend class affected by the tuition that is now a sunk