Economics 500 Examination 1 – Fall 2005 1. Tracy and Salif devote each workday to producing either telephones or pizzas. On any given day Tracy can produce either 5 telephones or 20 pizzas, while Salif can produce either 20 telephones or 10 pizzas. Suppose that trade can take place between these two workers. a. Which individual has an “absolute advantage” in the production of telephones? Clearly explain. (2 points) Salif has an absolute advantage in the production of telephones, since he can producer more per day (20>5). b. Which individual has a “comparative advantage” in the production of pizzas? Clearly explain. (4 points) Salif’s opportunity cost for producing pizzas is 21020==SPOC ; Tracy’s opportunity cost for producing pizzas is 41205==TPOC . Since SPTPOCOC < , Tracy has a comparative advantage in the production of pizzas. c. Determine the maximum number of pizzas that these two individuals can produce collectively. (2 points) If both workers spend all of their time making pizzas, they can collectively produce a total of 20+10=30 pizzas. d. Which individual should produce “the first telephone” for this society? Clearly explain. (4 points) Since Tracy has a comparative advantage in the production of pizzas, it must be that Salif has a comparative advantage in the production of telephones. Thus, the initial units of telephones should be produced by Salif. e. Clearly argue the following: “Without specialization and trade, it is not possible for either individual to consume 10 telephones and 10 pizzas. However, with specialization and trade, it is possible for both individuals to consume 10 telephones and 10 pizzas.” (4 points) Without trade, Tracy can never make more than 5 telephones. Without trade, Salif cannot produce any telephones if he produces 10 pizzas. Thus, neither individual could have (10,10) without trade. On the other hand, if Tracy spends all of her time making pizzas and Salif spends all of his time making telephones, they will collectively produce 20 pizzas and 20 telephones. From here it would be possible to have each individual consume (10,10) after trade with each other.2. Consider a market with Supply and Demand as illustrated below: a) State the “Law of Demand.” Does the “Law of Demand” appear to be satisfied in this market? Explain. (8 points) The “Law of Demand” states that, all other factors fixed, there is an inverse relation between price and quantity demanded. Since the demand curve above is “downward sloping,” this law appears to be satisfied. b) Based upon the figure above, can you determine if there is “excess demand,” “excess supply,” or neither at a price of 50.10=p ? Explain. (8 points) From the graph above, there is “excess supply” at a price of 25.7=p , in that )25.7()25.7( SD < . Since both the Law of Demand and Law of Supply appear to hold, it follows that )25.7()50.10( DD< and )50.10()25.7( SS < . Together these conditions imply )50.10()50.10( SD<. That is, there is “excess supply” at a price of 50.10=p . c) If Supply were to increase (with no change in demand), how would the equilibrium price and quantity in this market change? Explain. (8 points) If supply were to increase, the “new supply curve” would be to the right of the initial supply curve, as illustrated below. In general, such a change will lead to an increase in equilibrium quantity and decrease in equilibrium price. $ Q Supply Demand 7.25 1,500 2,300 $ Q Initial Supply Demand New Supplyd) Based upon the figure above, can you determine if a price floor of 25.7=fp would affect this market? Explain. (8 points) A “price floor” is a minimum allowable price, set by law. Based upon the graph, the equilibrium price in this market (without any price controls) is such that 25.7*<p . Therefore, imposing a price floor of 25.7=fp will have an effect on this market, since *ppf> . 3. Annika is an avid golfer. The table below summarizes her “total benefit” from playing golf (measured in dollars) for different levels of rounds played per week. Rounds of Golf Per Week Total Benefit Marginal Benefit 0 0 1 100 100 2 180 80 3 240 60 4 280 40 5 305 25 6 315 10 7 310 -5 a) Complete Annika’s Marginal Benefit schedule for each level of “Rounds of Golf Per Week” listed in the table (put your answers in the column entitled “Marginal Benefit”). (6 points) b) Suppose each round of golf costs $30. How many rounds will Annika play per week? Clearly explain. (8 points) This pricing structure implies MC=30 for each round of golf. In this case she would optimally choose to play 4 rounds per week (since MB>MC up to this level, while MC>MB beyond this level). c) Suppose Annika can purchase a “weekly membership” for $150, which allows her to play as many rounds of golf as she would like for “free” (that is, at no additional cost). If Annika purchases this membership, how many rounds will she choose to play? Clearly explain. (8 points) For this pricing structure MC=0 for each round of golf. In this case she would optimally choose to play 6 rounds of golf per week (since MB>0 up to this point, but MB<0 beyond this point).d) If Annika has the choice of either: “purchasing rounds of golf at a per unit price of $30” (as described in part (b)) or “purchasing a weekly membership for $150” (allowing her to play as many rounds as she wants for free, as described in part (c)), which of these two options will she choose? Clearly explain. (6 points) Under the pricing structure described in part (b), Annika would play 4 rounds of golf per week. She would incur a Total Cost of $120, while realizing a Total Benefit of $280. From here, her net surplus in this case is simply 280-120=160. Under the pricing structure described in part (c), Annika would play 6 rounds of golf per week. She would incur a Total Cost of $150, while realizing a Total Benefit of $315. From here, her net surplus in this case is simply 315-150=165. Since she would realize a greater net surplus when purchasing the weekly membership, this is the choice she should rationally make. 4. Imagine a society that produces only two goods, “Guns” and “Roses.” The Production Possibilities Curve for this society is illustrated below. Considering each of the following statements individually (that is, “when considering