answers to problem set 1

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                                          Problem Set 1 Answer Key


a) False. Even if a PPF was linear and not concave,
every different point on a it would still represent
different quantity combinations of the two goods
producable. So concaveness has nothing to do with
the possible quantities of the two goods, but it is
rather about increasing opportunity costs; which is
because producing more and more of one particular
good would require giving up on more and more of
the other good.

For instance, in an economy that produces tanks and
butter only, as the economy specializes more in the production of tanks, it would soon have to employ
resources which were in fact more efficient in the production of butter and less efficient in the production of
tanks. This would mean increasing opportunity costs for tanks, as the production of every additional tank
would result in having to give up on more butter than the production of the previous tank did. Therefore, the
concaveness of the PPF represents the increasing opportunity cost with increased production of a good.

b) False. This sentence shows that videos are inferior goods. An inferior good is one whose quantity
demanded decreases when income increases. All Giffen goods are inferior goods as well but most inferior
goods are not Giffen goods and there is nothing in this sentence to indicate that videos are Giffen goods.
                             Although it is difficult to find good examples of Giffen goods, a common example
                             is potatoes. During the Irish Great Famine (where approximately one million
                             people died of starvation and diseases between 1845-1892), people were very
                             poor and potatoes were the cheapest food available. As their money was not
                             enough to buy enough amounts of better food such as meat, in order to stay alive,
                             people depended on potatoes as their primary source of food. Yet, paradoxically,
                             people did not increase their potatoe consumtion when potatoe prices dropped,
                             because you know, it’s not really very enjoyable to eat potatoes all the time. So,
                             when potatoes became cheaper people started to eat less of them so they could
spare some money in order to buy better food for a change of taste, like some temporary ‘luxury’. So
accordingly, whenever the prices of potatoes went back up, people immediately stopped eating better food
and increased their potatoe demand, because they knew they could starve if they didn’t. The problem was
that, even if they gave all their money, the amounts of the “better food” that they could buy would not be
enough to keep them well fed and they would remain hungry. They were simply too dependent on potatoes.
This paradoxical situation serves a brief explanation of Giffen goods. Iin our question, the demand for videos
does not show any of such characteristics, meaning videos are not Giffen goods but they are just inferior goods
here, in comparison to movies.


                                            Hamburgers         Tables
                                            (per hour)         (per hour)
                                Tom         50                 25
                                Mike        20                 15

        For Tom, the opportunity cost of preparing a hamburger is 0,5 tables. That means, in order to prepare
two additional hamburgers, Tom has to give up waiting one table. For Mike it is 0,75 tables; which means Mike
has to give up waiting 3 tables in order to prepare 4 additional hamburgers. In this case, Tom has absolute
advantage in both types of work, yet he has comparative advantage only in the preparation of hamburgers,
because the degree of his absolute advantage is higher in the preparation of hamburgers than in waiting

Production Possibilities Frontier for Tom                Production Possibilities Frontier for Mike
(one week)                                               (one week)

c) In 20 hours, Tom would produce 500 hamburgers and wait 250 tables while Mike would produce 200
hamburgers and wait 150 tables. The aggregate production would be 750 hamburgers and 400 tables.

d) Tom should be the cook in the stand, because he has comparative advantage in preparing hamburgers.
Although Mike has absolute disadvantage in both cooking and table waiting, the degree of his absolute
disadvantage is lower in waiting tables. So the aggregate output would be maximized only if Tom spent all of
his work hours in the kitchen and Mike just waited tables. If each specialized completely in their respective
area of comparative advantage, the aggregate production in one week would be 1000 hamburgers prepared
and 300 tables waited. No other division of labor could produce an output as high as this.


     When the drought strikes,          Sugar cane is the primary
     farmers don’t have much            ingredient for sugar. A sugar
     canes to crop so the               producer would hope sugar canes
     production              drops.     were as cheap as possible. When
     Considering the demand             they are more expensive than ever
     curve stays the same, this         because of the drought, it means
     moves the equilibrium from         sugar is more expensive than ever
     point E1 to point E2, resulting    as well. So the the sugar prices rise
     in higher prices (P2>P1) and       (P2>P1)      and     the    quantity
     lower quantity demanded /          demanded of sugar falls as well
     sold (Q2<Q1).                      (Q2<Q1).

                              Honey is a good substitute for sugar.
                              When the quantity demanded of sugar
                              decreases because of high prices,
                              people tend to consume more honey.
                              So the honey demand curve shifts to
                              the right, resulting in a higher price
                              (P2>P1) and higher quantity purchased
                              in equilibrium (Q2>Q1) .


                                 Goofy                      Roger Rabbit

                            QS1 = 10 + 20 P               QS2 = 20 + 10 P

                               Demand for Comic Books = QD = 105 - 20 P


         Price per unit     Quantity        Quantity     Quantity supplied    Aggregate quantity
               ($)        Demanded QS1     supplied by    by Roger Rabbit          supplied
                                            Goofy QS1           QS2             QS = QS1 + QS2
              0,50             95              20               25                    45
               1               85              30               30                    60
              1,50             75              40               35                    75
               2               65              50               40                    90
              2,50             55              60               45                   105

b) There is only one row in the graph where the quantity demanded matches the quantity supplied, it is the
third line where the equilibrium price of one comic book is $ 1,50 and the equilibrium quantity is 75 comic
books. The other four situations are not fit for equilibrium.


     QS1 + QS2 = QD = 10+20P+20+10P = 105 - 20 P

    P EQ = 1,5
    Q S = 75

e) A price ceiling of $1 per comic book would cause the total demand to exceed total supply. When neither
Goofy nor Roger Rabbit could sell comic books for higher than $1, they would supply 60 units of comic books
in total while the demand is 85 units. There would be an excess demand of 25 units of comic books and
eventually, with lower sales and lower revenues, Roger Rabbit would not be able to propose to his love, Jessica

f) As quantity demanded highly exceeds quantity supplied, some portion of the demand is surely ineffective.
What really determines how many comic books will be purchased is the quantity supplied, because under the
circumstances of such a price ceiling, there will always be some extra quantity of demand waiting to come into
effect, in case the supply of comic books ever increases.

For a better understanding, let us imagine two different cases and their respective effects on the market; the
first one being a decrease in the price of craft paper and the second one being an increase in the income of
households. The first one; if there were to be a decrease in the price of craft paper, it would cost less to
publish comic books and both Goofy and Roger Rabbit would be able to supply more comic books at the price
of $1 per unit. This would shift the supply curve to the right, and -considering there was already an excess
demand in the market- would result in an increase in the quantity purchased. This example prooves that a
change in the supply can affect the quantity purchased. The second example; if there were to be an increase in
the income of Toontown households, it would still be impossible to purchase more than 60 comic books as
long as the quantity supplied of comic books remains fixed. Although an increase in household income would
shift the demand curve to the right, since the supply curve does not move, Goofy and Roger Rabbit would not
be able to supply any more than 60 books and that would result in even more excess demand. This example
proves that - under the price ceiling of $1 - it is not the quantity demanded which determines the quantity
purchased. The quantity supplied solely determines the quantity purchased.

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