Professor Christina Romer SUGGESTED ANSWERS TO PROBLEM SET 1

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1 Economics 2 Spring 2017 rofessor Christina Romer rofessor David Romer SUGGESTED ANSWERS TO ROBLEM SET 1 1.a. The opportunity cost of a point on your economics exam is 2 points on your chemistry exam. It takes 30 minutes of studying to raise your economics score by a point. But each 30 minutes that you spend studying for your economics exam is 30 minutes that you re not spending studying for your chemistry exam, and those 30 minutes would have raised your chemistry score by 2 points. (Note that the opportunity cost of a point on your economics exam is 2 points on your chemistry exam, not 2 points on your chemistry exam plus 30 minutes of your time. The problem says that you were going to spend the two hours studying. So if you didn t spend the 30 minutes studying for the economics exam, you would spend it studying for the chemistry exam. Thus, if you decide not to spend the 30 minutes studying for economics, you would get another 2 points on your chemistry exam; you wouldn t get the 2 points plus 30 minutes of free time.) b. The opportunity cost is $250. If you sell the Tickle Me Elmo on ebay, you have $250 more than you would have if you gave it to your child. (It s true that you would only have $225 more than you had before you bought the doll to start with. But regardless of whether you give the doll to your child, the $25 is already gone. The difference between what you have if you sell the doll and what you have if you give it to your child is $250, so that s what you d be giving up by giving the doll to your child.) c. No. Regardless of whether you went to graduate school or took a job, you would have living expenses. Thus, they aren t part of the cost of going to graduate school. On the other hand, if you didn t go to graduate school, you wouldn t have to pay tuition and you d earn a salary. Thus both tuition and the foregone salary are parts of the cost of going to graduate school. 2.a. The C for civilian and military goods and services shows the various combinations of these two types of output that the economy can produce using exactly all of the available resources. This C for civilian and military output probably has the conventional bowed-out shape. Some labor and capital are well suited to the production of civilian goods and services, while other labor and capital are well suited to the production of military goods and services. Therefore, the opportunity cost of producing either of these types of output rises as we produce more of it. Military C Civilian The point where the C intersects the vertical axis is the point on the C where civilian output is zero. Thus, it shows the amount of military goods and services we could get if we devoted all of our resources to producing military output and none to civilian output. Similarly, the point where the C intersects the horizontal axis shows the amount of civilian goods and services we could get if we devoted all of our resources to producing civilian output. The slope of the C at a given point shows the amount that military output would fall by if we increased civilian output by 1 unit. Thus, the slope is (minus) the opportunity cost of civilian goods.

2 2 b. If there is no change in the productivity of capital and labor in producing civilian goods and services, then the maximum amount of civilian output we can produce doesn t change. Thus the point where the C intersects the horizontal axis doesn t change. But since capital and labor are more productive in producing military goods and services than before, if we devote some of our capital and labor to the military sector, we get more military output than before. Thus at any point except where the C intersects the horizontal axis, the new C is above the old C. That is, the C shifts outward asymmetrically from something like C 1 to something like C 2. Military C 1 C 2 Civilian c. The problem focuses on a change in the composition of production, not on the level of production. This means that it describes a movement along the C. Since a decision to spend more on military goods and services doesn t change the economy s productive possibilities, it can t move us to a point outside the old C. Given our productive capacities, with the economy starting at full employment (so that we re already on the C), the only way we can have more military goods and services is by having fewer civilian goods and services. Thus the change would move us from one point on the C (such as point A) to another point (such as point B) with more military output and less civilian output. Military B A C Civilian 3.a. The opportunity cost of a croissant for a worker is the number of baguettes he or she could produce in the time it takes to produce 1 croissant. Since Juliette could produce 3 croissants in an hour or 3 baguettes, her opportunity cost of 1 croissant is 1 baguette. Likewise, her opportunity cost of 1 baguette is 1 croissant. The opportunity costs for each of the workers are given in the table below. Opportunity Cost of 1 Croissant (in Baguettes) Opportunity Cost of 1 Baguette (in Croissants) Juliette 1 1 Marie 4 ¼ ierre ⅓ 3 b. When there is no specialization, we think of each worker splitting his or her time in the same way as the others. That is, if one worker produces croissants for 1 hour and baguettes for 5 hours, the other two workers also produce croissants for 1 hour and baguettes for 5 hours. We don t allow one worker to spend more time on some activity than another worker. Since the workers always do the same thing, there s a constant opportunity cost for the collective. Every time the three workers work an hour producing baguettes, they produce 8 baguettes. Every time the three workers work an hour producing croissants, they produce 7 croissants. Therefore, for the collective as a whole, when there is no specialization, the opportunity cost of 1 croissant is ⁸ ⁷ baguettes.

3 The vertical intercept of the C shows the number of baguettes the three workers could produce in a day if they produced no croissants. Since they work for 6 hours per day and produce 8 baguettes per hour, they could produce 48 baguettes. The slope of the C is minus the opportunity cost of the good on the horizontal axis. Therefore, if we put croissants on the horizontal axis, the slope of the C for the collective, assuming no specialization, is ⁸ ⁷. Therefore, the C for the collective with no specialization is a line starting at 48 baguettes and 0 croissants, with a slope of ⁸ ⁷. The horizontal intercept shows the number of croissants the three workers could produce if they produced no baguettes. If the collective produced no baguettes, it could Baguettes 48 C without specialization Croissants produce 42 croissants (7 croissants per hour times 6 hours). Notice that this is the point we get to if we start at no croissants and 48 baguettes and draw a line with a slope of ⁸ ⁷ until we get to the horizontal axis. The C for the collective without specialization is a straight line because the opportunity cost of a croissant doesn t rise as more are produced. This is true because each worker s abilities are constant and we are forcing the three workers to always split their time in the same way. Therefore, every time they produce one more croissant, they give up ⁸ ⁷ baguettes. c. When we allow the workers in the collective to specialize, they will no longer split their time in exactly the same way. Instead, they will divide the activities according to comparative advantage. This means that as we think about producing progressively more of one of the goods, the worker with the lowest opportunity cost produces first, the second lowest next, and the highest last. If the collective decides to have the workers specialize according to who has the lower opportunity cost, it will use ierre to produce croissants first, then Juliette, and then Marie. The specialization will cause the slope of the C to change as we move along it. Between 0 croissants and the maximum amount that ierre can produce in a day (which is 18 croissants), the relevant opportunity cost is ierre s he is the one switching between baguette production and croissant production; Juliette and Marie are just making baguettes. Therefore, the slope of the C is ⅓ in this range. Between 18 croissants and 36 croissants, which is the maximum amount ierre and Juliette can produce together, the relevant opportunity cost is Juliette s she is the one who is switching between the two activities; Marie is just producing baguettes and ierre is just producing croissants. Therefore, the slope of the C is 1 in this range. Finally, between 36 croissants and 42 croissants, which is the maximum number of croissants the three can produce if they all just produce croissants, the relevant opportunity cost is Marie s she is the one switching between the two activities. Therefore, the slope of the C is 4 in this range. The vertical intercept of the C is 48 baguettes the total number of baguettes the three workers can produce if they each spend all 6 hours making baguettes. The horizontal intercept is 42 croissants the total number of croissants the three workers can produce if they each spend all 6 hours making croissants. 42 3

4 4 With specialization, the C of the collective has two kinks in it. This reflects the fact that with specialization, the opportunity cost rises as the collective produces more of a good. The slope of the C changes from ⅓ (ierre s opportunity cost) for the first segment, to 1 (Juliette s opportunity cost) for the second, and finally to 4 (Marie s opportunity cost) for the third. This happens simply because the collective uses the worker with the lowest opportunity cost first, the next lowest opportunity cost second, and so on. As we add more and more workers, the C would start to take on its characteristic curved shape. Baguettes C with specialization Croissants The quantities of croissants and baguettes at each kink point are calculated by thinking about how much the workers can produce. The first kink occurs at the point where ierre is producing croissants full time and Juliette and Marie are producing baguettes full time. When ierre is spending 6 hours producing croissants, he will make 18 croissants; when Juliette and Marie are producing baguettes full time, they will make 42 baguettes (18 from Juliette and 24 from Marie). The second kink point occurs at the point where ierre and Juliette are both producing croissants full time and Marie is making baguettes full time. If ierre and Juliette work 6 hours producing croissants, they will make 36 croissants (18 from ierre and 18 from Juliette); when Marie is producing baguettes for 6 hours, she will make 24 baguettes. 4.a. As in lecture, for Robinson the opportunity cost of 1 coconut is 1 fish, and for Friday the opportunity cost of 1 coconut is 4 fish. And as in lecture, if Robinson and Friday both spend all their time fishing, they will catch 54 fish (6 from Robinson and 48 from Friday), and if they spend all their time gathering coconuts they will get 18 coconuts (6 from Robinson and 12 from Friday). However, what happens between the two extremes is different than in lecture. Starting from the point where they are both spending all day catching fish, suppose they decide to gather some coconuts. The rule is that Friday must be the first one to do this. For each coconut he gathers, he catches 4 fewer fish. Thus the slope of their production possibilities over this range is 4. Robinson isn t allowed to gather any coconuts until Friday is spending all his time doing so. Thus the slope is 4 up to the point where Robinson is still spending all his time fishing, but Friday is spending all his time gathering coconuts. At this point, they re getting 6 fish and 12 coconuts. Beyond that point, if they want more coconuts, it s Robinson who switches from fishing to coconut-gathering. Thus over that range, the slope is determined by Robinson s opportunity cost, and so is 1. Fish Coconuts

5 The reason that Robinson and Friday s production possibilities when they follow the rule has this strange shape is that the rule makes them specialize according to comparative disadvantage: the rule requires that if only one of them is gathering coconuts, it s Friday, who has the higher opportunity cost of gathering coconuts, and that if only one of them is fishing, it s Robinson, who has the highest opportunity cost of catching fish. Thus their production possibilities when they follow the rule are worse than if they didn t specialize at all but just divided their time the same way. b. When Robinson can catch 4 fish in an hour, he and Friday have the same opportunity costs: the opportunity cost for either one of gathering a coconut is 4 fish. (For Robinson, it would take him an hour to gather a coconut, and in that time he could have caught 4 fish. For Friday, it would take him half an hour to gather a coconut, and in that time he could also have caught 4 fish.) Likewise, the opportunity cost for either one of a fish is ¼ coconut. So, regardless of whether they trade off between fish and coconuts by having Robinson gather coconuts, or by having Friday do it, or by both switching some of their time from fishing to coconut-gathering, for each additional coconut they gather, they catch 4 fewer fish. Thus, there are no gains from specialization. 5 The diagram shows this graphically. If both Robinson and Friday spend all their time fishing, they will catch 72 fish in a day. If the both spend all their time gathering coconuts, they will gather 18. In between, regardless of who specializes in what (or whether they specialize at all), for each extra coconut they gather, they catch 4 fewer fish. Thus either with or without specialization, the C is a straight line between the two extremes. 72 Fish C with or without specialization Coconuts 18 5.a. The information that limes have important health benefits will mean that at a given price, American consumers want to buy more limes. This corresponds to a shift out in the demand curve (from to D 2). The equilibrium price and quantity of limes will both rise (from to 2 and from 1 to 2, respectively). 2 D b. Limes and avocados are complements: they are often consumed together. To put it another way, consuming more avocados makes consuming limes more attractive, and consuming fewer avocados makes consuming limes less attractive. When the price of avocadoes rises because of a shift in supply, consumers buy fewer of them. As a result, consumers seeking to make themselves as well off as possible find that they can have more total happiness if they D 2

6 also buy fewer limes (and buy more of goods whose enjoyment isn t linked to their consumption of avocados salsa, for example). As a result, at a given price of limes, fewer will be demanded than before. This corresponds to a shift back in the demand curve (from to D 2). The equilibrium price and quantity of limes will both fall (from to 2 and from 1 to 2, respectively). c. Before the imposition of the price ceiling, the equilibrium price of limes was and the equilibrium quantity was 1. The statement that the price ceiling is binding means that it s less than the price where supply and demand intersect that is, that it s below. At the price ceiling of, the quantity supplied ( S) is less than the quantity demanded ( D). The price of limes will fall (from to ), and the quantity bought and sold will fall (from 1 to S). Because the quantity demanded will exceed the quantity supplied at the new price, there will be a shortage of limes. d. A tax that is paid by consumers shifts the demand curve down by the amount of the tax: consumers are willing to pay less at a given quantity because they know they will also have to pay the tax. Because the tax is paid by consumers, the supply curve isn t affected. The downward shift of the demand curve lowers the equilibrium quantity (from 1 to 2). In addition, the equilibrium price, which is what firms receive, also falls (from to 2). The price paid by consumers was, but after the tax is imposed the total amount they pay for each lime is 2 plus the tax. Since the distance between and D 2 is the amount 2 + tax 2 Shortage 2 1 Tax (25 ) of the tax, we find this amount paid by consumers by looking at the point on corresponding to the new equilibrium quantity ( 2). With a normal, downward-sloping demand curve and a normal, upward-sloping supply curve, the tax decreases the amount suppliers receive for the good and increases the amount that consumers pay. 6.a. For most consumers, there are many close substitutes for pepperoni pizza. Most obviously, there are other types of pizza; but there are also meatball subs, burgers, calzones, and so on. With the presence of many close substitutes, one would expect a small price increase to lead to a large reduction in the quantity of pepperoni pizza demanded, and a small price decrease to lead to a large increase in the quantity demanded. If so, the price elasticity of demand is fairly high. (Of course, one could try to make an argument for a low elasticity. There are some consumers who strongly prefer pepperoni pizza to any of the usual alternatives. The quantity of pepperoni pizza that these consumers demand may be relatively unresponsive to the price. If these consumers are the source of most of the demand for pepperoni pizza, the elasticity of demand is fairly low.) b. The shift up of the supply curve will lead to a fall in quantity and a rise in price as we move along the demand curve. In part (a), we argued that the price elasticity of demand for pepperoni pizza is probably fairly high. If the elasticity of demand is greater than 1, the percentage fall in the quantity of pepperoni pizza will be larger than the percentage rise in the price. As a result, total spending on pepperoni pizza (which is price times quantity) will fall. S 1 D D 2 6

7 7 All of this is shown is the diagram. When the price elasticity of demand is high then, over the relevant range, the demand curve is fairly flat. In this case, when the supply curve shifts up, the percentage S 2 fall in quantity (the percentage change from 1 to 2) is larger than the percentage rise in price (the 2 percentage change from to 2). Total spending is the product of price and quantity. Thus it is shown by the shaded rectangles in the diagram. For example, total spending before the shift in supply is given by the rectangle with corners at the origin, 1 on the horizontal axis, on the vertical axis, and the 2 1 intersection of and. This rectangle has width 1 and height, and so its area is 1 times, which is total spending on pepperoni pizza. Total spending after the shift in supply is shown by the rectangle with width 2 and height 2. As the diagram shows, with a high price elasticity of demand, total spending falls when supply shifts up.