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CSUN ECON 500 - Exam #1 - Answer Key

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ECON 500 – Fall 2004. Exam #1 - Answer Key. 1. Suppose you have won $100 in a football pool. You are deciding between the following two options: I. spending the money now on a nice dinner for two at a fancy seafood restaurant (which would cost exactly $100) II. putting the entire sum of money away for exactly one year in a bank account that pays 4% interest. What is the true cost of the dinner at the seafood restaurant? Clearly explain. (10 points) The "true cost" of the dinner at the seafood restaurant is "what must be given up in order to get the dinner." If the $100 were put in a bank account that pays 4% interest for exactly one year, you will have "$104 one year from now." Thus, the "true cost" of the dinner at the seafood restaurant is "$104 one year from now." 2. Imagine a society that produces military goods (“guns”) and consumer goods (“butter”). The Production Possibilities Frontier for guns and butter is illustrated below. a. In the figure above, identify a point that is impossible for this economy to achieve (label this point “U”). In the figure above, identify a point that can be achieved, but is inefficient (label this point “I”). (4 points) b. Suppose the society has two political parties, the Hawks (that want a strong military, but still some consumer goods) and the Doves (that want a smaller military, and more consumer goods). In the figure above: identify Guns Butter UDHIa point that the Hawks might argue in favor of (label this point “H”); identify a point that the Doves might argue in favor of (label this point “D”). (4 points) c. Suppose that an aggressive neighboring country reduces the size of its military. As a result, both Hawks and Doves reduce their desired level of Guns by the same amount. Which party would realize a bigger “peace dividend,” measured by the resulting increase in butter production. Clearly Explain. (4 points) The opportunity cost of butter is lower at point H than at point D. As a result, for a common decrease in the amount of guns, the increase in butter will be larger starting at H as opposed to starting at D. Thus, the "peace dividend" is larger for "Hawks" than for "Doves." 3. Consider a market in which Supply and Demand are respectively given by the inverse functions qqPS2)( = and qqPD324)(−=. a. Determine the functional form of )( pD . (3 points) ppD318)( −= b. Determine the number of units that consumers are willing and able to purchase at a price of $3 per unit. (3 points) At a price of $3 per unit, consumers are willing and able to purchase 718)3(8)3(31=−=−=D units.c. Suppose “Supply Changes” so that the new inverse supply function is qqPnewS4)( = . Graphically illustrate Supply both before and after this change. Does this change correspond to an “Increase in Supply” or a “Decrease in Supply”? Clearly explain. (4 points) The change in Supply illustrated above is clearly a Decrease in Supply, since for any positive price, the corresponding quantity is less along the new Supply Curve than along the initial Supply Curve. 4. Clearly explain why each of the following statements is either correct or incorrect. (6 points each) a. "If the price of oil increases (with all other factors fixed), demand must decrease." This statement is incorrect, since a change in price (with all other factors fixed) will result in a change in quantity demanded, not a change in demand. b. "Dennis has a voucher from Southwest Airlines (with no expiration date) for 'one free round trip ticket, anywhere Southwest flies in the continental United States.' The true cost of using this voucher to fly to Las Vegas is zero, since he doesn't have to pay any money to obtain the ticket." This statement is incorrect, since by using the ticket Dennis has to give up "flying to his favorite destination other than Las Vegas." Since he does have to give something up in order to get the ticket to Las Vegas, the cost of the ticket to Las Vegas is not zero. P Q 0 0 newSinitialSc. "When deciding how much to study for an exam, you should always increase your 'study time' if doing so increases your expected grade on the exam." This statement is incorrect, since a rational decision maker should not only "think on the margin," but should be sure to consider both "marginal benefits" and "marginal costs." The statement above considers only "marginal benefits." 5. Nick and Chris devote each workday to producing either “apples” or “bananas.” On any given day Nick can produce either 8 pounds of apples or 16 pounds of bananas, while Chris can produce either 6 pounds of apples or B pounds of bananas. a. Based upon the provided information, which individual has an absolute advantage in the production of apples? Explain. (4 points) Nick has an absolute advantage in the production of apples, since he can produce a greater quantity in a given day (68 > ). b. Based upon the provided information, which individual has an absolute advantage in the production of bananas? Explain. (4 points) Without knowing the value of B, it is not possible to determine which individual has an absolute advantage in the production of bananas. If 16<B , Nick has an absolute advantage in the production of bananas; if 16>B , Chris has an absolute advantage in the production of bananas. c. Specify a value of B for which Chris has a comparative advantage in the production of apples. Justify your answer. (6 points) 6BCAOC = and 2816==NAOC . Chris has a comparative advantage in the production of apples when NACAOCOC < , which is true for any 12<B. d. In general, is it ever possible for one individual to simultaneously have a comparative advantage in the production of both apples and bananas? Clearly explain. (4 points) In general, this is not possible. Begin by supposing that Chris has a comparative advantage in the production of apples, in which case NACAOCOC < . Recall that CBCAOCOC1= and NBNAOCOC1= . So, if Chris has a comparative advantage in the production of apples, it follows that NBCBOCOC11< . From here, CBNBOCOC < , implying that Nick must have a comparative advantage in the production of bananas.6. a. State the “Law of Demand.” (6 points) The "Law of Demand" states that, holding all other factors constant, there is an inverse relation between price and quantity demanded. b. If demand is given by the


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