Take Home Exam #1 – Answer Key. ECON 500 – Summer 2004. 1. The company you manage has already invested $50,000 in developing a new product, but the development is not quite finished. Suppose it would cost you an additional $40,000 to finish development and make the product. a. At a recent meeting, your salesperson reported that the expected revenues from this new product are $75,000. Should you go ahead and finish development and make the product? Clearly explain. (5 points) MCMB=>= 000,40000,75 . Since marginal benefits exceed marginal costs, “finish development and make the product.” b. Suppose instead that your salesperson reported that the expected revenues from this new product are $x. For what values of x should you choose to not finish development of this product? Clearly explain. (5 points) You should choose to not finish development of this product if marginal benefits are less than marginal costs, which will be the case if and only if 000,40<x. 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 which is impossible for this economy to achieve (label this point “U”). In the figure above, identify a point which 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 Guns Butter UI HDsmaller military, and more consumer goods). In the figure above: identify a 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 50%. Which party would realize a bigger “peace dividend,” measured by the resulting increase in the level of output of butter? Clearly explain. (6 points) First note that dhgg > (that is, the Hawks desire more guns than the Doves). As a result, the desired reduction in guns is greater for the Hawks than for the Doves (that is, dhgg2121> ). This, along with the fact that the Opportunity Cost of butter increases as we move “down” the Production Possibilities Frontier (from “low butter, high guns combinations” to “high butter, low guns combinations”), implies that the Hawks will realize a bigger “peace dividend” than the Doves. 3. Between 2002 and 2004 the equilibrium price for avocados increased from $1.63 to $1.87, while the equilibrium quantity decreased by 10,000 units. Clearly explain whether or not this observed change could be a result of: i. a decrease in Demand with no change in Supply. (6 points) A decrease in Demand with no change in Supply must lead to a decrease in both equilibrium price and equilibrium quantity. Therefore, the observed change could not have been a result of a decrease in Demand with no change in Supply. ii. a simultaneous increase in Demand and decrease in Supply. (6 points) A simultaneous increase in Demand and decrease in Supply must lead to an increase in equilibrium price. However, equilibrium quantity may increase, decrease, or remain the same as a result of this simultaneous change. Therefore, an observed increase in equilibrium price and decrease in equilibrium quantity could be a result of a simultaneous increase in Demand and decrease in Supply. iii. a simultaneous increase in both Supply and Demand. (6 points) A simultaneous increase in both Supply and Demand must lead to an increase in equilibrium quantity. Therefore, the observed change in price and quantity could not be a result of a simultaneous increase in both Supply and Demand.4. Abby and Ryan devote each workday to producing either “hamburgers” or “bicycles.” On any given day Abby can produce either 100 hamburgers or 10 bicycles, while Ryan can produce either 64 hamburgers or 8 bicycles. Suppose that trade can take place between these two individuals. i. Clearly explain which individual has an Absolute Advantage in the production of hamburgers. (3 points) Abby has an absolute advantage in the production of hamburgers, since she can produce more in a single day (64100 > ). ii. Clearly explain which individual has a Comparative Advantage in the production of hamburgers. (3 points) RHAHOCOC ==<==6488110110010. Since Abby has the lower Opportunity Cost, she has a comparative advantage in the production of hamburgers. iii. Graphically illustrate the Production Possibilities Frontier for this “two person economy.” Clearly label each intercept, as well as the slope of this curve at each point. (6 points) bicycles hamburgers 164 0 0 100 18 8 Slope = 101−=−AHOC Slope = 81−=−RHOCiv. When producing 6 bicycles as efficiently as possible, how many hamburgers are these two individuals able to produce? Clearly explain. (4 points) When producing 6 bicycles as efficiently as possible: Abby must spend all day making hamburgers, while Ryan must spend three quarters of the day making bicycles and one quarter of the day making hamburgers. As a result, Abby will produce 100 hamburgers while Ryan will produce 16 hamburgers. Collectively they will produce 116 hamburgers. v. Give an example of levels of consumption for each individual that are attainable with specialization and exchange, but unattainable without. Explain. (4 points) With trade, it is possible for Abby to consume ()( )4,65, =AABH and for Ryan to consume ()()4,35,=RRBH , since this requires joint output to be ()( )8,100, =BH (which will be produced if Abby spends all day making hamburgers and Ryan spends all day making bicycles). Without trade: if Abby wants 4 bicycles she can only produce 60 hamburgers; if Ryan wants 4 bicycles he can only produce 32 hamburgers. 5. Consider a market in which Supply and Demand are respectively given by the inverse functions qqPS2)( = and qqPD320)(−=. i. Determine the functional forms of )( pD and )( pS . (4 points) ppD31320)( −= and ppS21)(=. ii. Determine the equilibrium quantity and equilibrium price in this market. (6 points) 4*=q and 8*=p. iii. Suppose “Supply Changes” so that the new