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Principles of economics solutions
Typology: Exercises
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the frontier), point B is an inef- ficient point (inside the frontier), and point C is an infeasible point (outside the frontier).
B
A
Quantity of Food Produced
Quantity of Clothing Produced
C
Figure 1
The effects of a drought are shown in Figure 2. The drought reduces the amount of food that can be produced, shifting the production possibilities frontier inward.
Quantity of Food Produced
Quantity of Clothing Produced PPF2 PPF
Figure 2
Microeconomics is the study of how households and firms make decisions and how they interact in markets. Macroeconomics is the study of economy-wide phenom- ena, including inflation, unem- ployment, and economic growth.
for gathering coconuts and catch- ing fish. If Crusoe lives by himself, this frontier limits his consump- tion of coconuts and fish, but if he can trade with natives on the island, he will possibly be able to consume at a point outside his production possibilities frontier.
Coconuts Gathered
Fish Caught
Figure 1
group of sellers (who determine supply) of a particular good or service. A perfectly competitive market is one in which there are many buyers and many sellers of an identical product so that each has a negligible impact on the market price.
Price of Number of Pizza Pizza Slice Slices Demanded
$0.00 10 0.25 9 0.50 8 0.75 7 1.00 6 1.25 5 1.50 4 1.75 3 2.00 2 2.25 1 2.50 0
The demand curve is graphed in Figure 1.
Price of Pizza Slice
0
$2.
2 4 6 8 10
Demand
Number of Pizza Slices Demanded Figure 1
Examples of things that would shift the demand curve include changes in income, prices of related goods like soda or hot dogs, tastes, expectations about future income or prices, and the number of buyers. A change in the price of pizza would not shift this demand curve; it would only lead to a movement from one point to
another along the same demand curve.
Price of Number of Pizza Pizza Slice Slices Supplied
$0.00 0 0.25 100 0.50 200 0.75 300 1.00 400 1.25 500 1.50 600 1.75 700 2.00 800 2.25 900 2.50 1000
The supply curve is graphed in Figure 2.
Price of Pizza Slice
0
$2.
200 400 600 800 1000
Supply
Number of Pizza Slices Supplied Figure 2
Examples of things that would shift the supply curve include changes in prices of inputs like tomato sauce and cheese, changes in technology like more efficient pizza ovens or automatic dough makers, changes in expectations about the future price of pizza, or a change in the number of sellers. A change in the price of pizza would not shift this supply curve; it would only lead to a movement from one point to another along the same supply curve.
If the tax is imposed on car sellers, as shown in Figure 2, the sup- ply curve shifts upward by the amount of the tax ($1,000) to S 2. The upward shift in the supply curve leads to a rise in the price paid by buyers to P 2 and a decline in the equilibrium quantity to Q 2. The price paid by buyers increases by P 2 – P 1 , shown in the figure as ΔPB. Sellers receive P 2 – 1,000, a decrease in what they receive by P 1 – (P 2 – $1,000), shown in the figure as ΔPS.
P 2 $1,
P 1
P 2
Quantity of Cars
Price of Cars
Q 2 Q 1
P B P S
S 2
S 1
D
Figure 2
Quantity of Turkey
Price of Turkey
Demand
P 1
CS
Figure 1
Quantity of Turkey
Price of Turkey
Supply
PS
P 1
Figure 2
Price of Turkey
P 1
Quantity of Turkey
Supply
Demand
PS
CS
Figure 3
PB
DWL DWL
P 1
Quantity of Cookies
Q 2
Price ofCookies
PS
Q 1
Demand
Supply
Figure 1
C
B (^) D
A
Price of Wool Suits
3
Quantity of Wool Suits
Domestic supply
Domestic demand
2 World price
Imports
Figure 1
a bargaining chip in international negotiations. In defending free trade in wool suits, you could argue that: (1) free trade creates jobs in some industries even as it destroys jobs in the wool-suit industry and allows Autarka to enjoy a higher standard of living; (2) the role of wool suits for the military may be exagger- ated; (3) government protection is not needed for an industry to grow on its own; (4) it would be good for the citizens of Autarka to be able to buy wool suits at a subsidized price; and (5) threats against free trade may backfire, leading to lower levels of trade and lower economic welfare for everyone.
pollution to a lower level and because the taxes raise revenue for the government. The tax is more efficient than regulation because it gives factories economic incentives to reduce pollution and to adopt new technologies that pollute less. The disadvantage of corrective taxes is that the government needs to know a lot of information to pick the right tax rate. Tradable pollution permits are similar to corrective taxes but allow the firms to trade the right to pollute with each other. As a result, the government does not need as much information about the firms’ technologies. The gov- ernment can simply set a limit on the total amount of pollution, issue permits for that amount, and allow the firms to trade the permits. This reduces pollution while allow- ing economic efficiency. Those opposed to pollution permits argue that it is wrong to put a price on pollution and wrong to allow even low levels of pollution, but economists have little sympa- thy with these arguments.
because at low levels of output, marginal cost is below average total cost, so average total cost is falling. But after the two curves cross, marginal cost rises above average total cost, and average total cost starts to rise. So the point of intersection must be the mini- mum of average total cost.
Quantity
Costs^ Marginal Cost
Average Total Cost
Figure 3
when price is less than average total cost.
Q Quantity
P
Price
Marginal Cost Average Total Cost
the quantity at which marginal revenue equals marginal cost. It finds the price to charge by find- ing the point on the demand curve that corresponds to that quantity.
keep companies from merging and generating synergies that increase efficiency. Some monopolies, especially natural monopolies, are regulated by the government, but it is hard to keep a monopoly in business, achieve marginal-cost pricing, and give the monopo- list an incentive to reduce costs. Private monopolies can be taken over by the government, but the companies are not likely to be well run. Sometimes doing nothing at all may seem to be the best solu- tion, but there are clearly dead- weight losses from monopoly that society will have to bear.
Q Quantity
Price, Cost, Revenue
P
Demand
Marginal Revenue
Average Total Cost
Marginal Cost
Figure 1
Brand names may be beneficial because they provide information to consumers about the quality of goods. They also give firms an incentive to maintain high quality, since their reputations are impor- tant. But brand names may be criticized because they may simply differentiate products that are not really different, as in the case of drugs that are identical with the brand-name drug selling at a much higher price than the generic drug.
Bonnie’s Decision
Confess Remain Silent
Confess Bonnie gets eight years Bonnie gets 20 years Clyde’s Clyde gets eight years^ Clyde goes free Decision (^) Remain Silent Bonnie goes free Bonnie gets one year Clyde gets 20 years Clyde gets one year
increase the total utility of society. A liberal would want to maximize the utility of the least well-off per- son in society, so a liberal would favor even greater redistribution. A libertarian would not want to redistribute income from Pam to Pauline as long as the process of earning income was a fair one.
100 Quantity of Pizza
Quantity of Pepsi
0
200
Budget constraint
Figure 1
Quantity of Pizza
Quantity of Pepsi
Figure 2
Substitution Effect Income Effect Quantity of Pizza
Quantity of Pepsi A
BC 1
I 1 I 2
BC 2
B C
Substitution Effect
Income Effect
Figure 3
surveying consumers to determine a basket of goods and services that the typical consumer buys. Prices of these goods and services are used to compute the cost of the basket at different times, and a base year is chosen. To compute the index, we divide the cost of the market basket in the current year by the cost of the market basket in the base year and multiply by 100. The CPI is an imperfect measure of the cost of liv- ing because of (1) substitution bias, (2) the introduction of new goods, and (3) unmeasured quality changes.
WE
Quantity of Labor
LE
unemployment
S
D
Wage W
LD LS
Figure 1
because it is the yardstick people use to post prices and record debts. Money is a store of value because people use it to transfer purchasing power from the pres- ent to the future.
(4) inflation-induced tax dis- tortions; (5) confusion and inconvenience; and (6) arbi- trary redistributions of wealth. Shoeleather costs arise because inflation causes people to spend resources going to the bank more often. Menu costs occur when people spend resources changing their posted prices. Relative-price variability occurs because as general prices rise, a fixed dol- lar price translates into a declin- ing relative price, so the relative prices of goods are constantly changing, causing a misallocation of resources. The combination of inflation and taxation causes distortions in incentives because people are taxed on their nominal capital gains and interest income instead of their real income from these sources. Inflation causes confusion and inconvenience because it reduces money’s ability to function as a unit of account. Unexpected inflation redistributes wealth between borrowers and lenders.
If the nominal exchange rate goes from 100 to 120 yen per dollar, the dollar has appreciated because a dollar now buys more yen.
real exchange rate decrease, and the trade balance moves toward surplus.
Real Interest Rate Real Interest Rate
Quantity of Dollars
Quantity of Loanable Funds Net Capital Outflow
Real Exchange Rate
r 2
E 2
E 1
Demand
Demand
r 1
Net capital outflow
S 1 S 2
S 1 S 2
Figure 1
workers, thus causing a rise in unemployment.
Equilibrium output
Quantity of Output
Price Level
Equilibrium price level
Aggregate supply
Aggregate demand
Figure 1
Unemployment Rate
Inflation Rate
Phillips curve
Figure 1
To see how policy can move the economy from a point with high inflation to a point with low infla- tion, suppose the economy begins at point A in Figure 2. If policy is used to reduce aggregate demand (such as a decrease in the money supply or a decrease in govern- ment purchases), the aggregate- demand curve shifts from AD 1 to AD 2 , and the economy moves from point A to point B with lower inflation, a reduction in real GDP, and an increase in the unemploy- ment rate.
Unemployment Rate
Inflation Rate
A
B
Phillips curve
Quantity of Output
AS
B
A
AD 2
AD
Price Level
Figure 2
Unemployment Rate
Inflation Rate
Short-run Phillips curve
Long-run Phillips curve
Figure 3
Unemployment Rate
Inflation Rate A
B
PC 1
PC 2
Quantity of Output
Price Level
P 1
P 2
AD
A
B
AS 1 AS 2
Y 1 Y 2
Figure 4
can only guess. Since economic conditions may change between the time a policy is implemented and when it takes effect, policy changes may be destabilizing. Thus, long lags suggest a policy that is passive rather than active.
with dollar-denominated debts. These benefits are all permanent. The costs of reducing inflation to zero are the high unemployment and low output needed to reduce inflation. According to the natural rate hypothesis, these costs are temporary.