Fundamental ideas in economics
Problem Set 1
The aim of this Problem Set is to help you understand some fundamental ideas in economics, the usefulness of models, and supply and demand. I hope you find it educational. Feel free to contact Mike or Cole if you have questions. Good luck! Part 1: First Principles (25 pts.)
1. Which of the 9 Principles is being illustrated best in each of the following
examples? In case we disagree on the “best” answer, explaining can help. (4 pts. each) a. In the past, medical knowledge was very limited– and doctors would often operate independently (*check out work by Atul Gawande to learn about this). As medical knowledge has expanded, doctors have started to focus on narrow areas within health– so that we don’t just have “doctors”, but “Anesthesiologists”, “Cardiologists” and “Pediatricians”– and all the while health care has been improving tremendously. By focusing on individual tasks, various types of doctors can become especially talented in their area, rather than somewhat competent in most areas– and (in some ways) society benefits as a result.
b. The San Francisco government wants to reduce childhood obesity. To do so, they ban the offering of free toys with unhealthy children’s meals. In response, restaurants offer toys for 10 cents with children’s meals– making the ban effectively useless. While the government’s intention was to get restaurants to sell less unhealthy food to kids, the policy did not sufficiently change the fact that it was in the self-interest of restaurants to sell unhealthy food to kids and to use toys as a means of making that happen.
c. .Barack Obama announces that he’s opening up his Presidential Library in your community. As several investors start bidding on individual plots of land, the real estate market initially destabilizes. In response to the increased demand, current owners raise their sales prices– until the amount of people wanting to buy the land equals the amount of people wanting to sell the land, and the price of each plot of land (after taking quality into account) is approximately the same across plots of land. Once prices are approximately the same again, the real estate market reaches a stable point where no one has any reason to change their behavior.
d. In rural African villages, people are underinvesting in health care, because they don’t appreciate that personal health investment (like getting dewormed) indirectly improves the wellbeing of society by reducing the spread of disease. Thus, if people invested more in health care, the broader society as a whole would be better off. To improve the wellbeing of the broader society, the government subsidizes health care so that people buy more of it.
2. Education economists estimate that an additional year of education leads to about an 8% in one’s annual income on average. Thus, many people conclude that college is definitely beneficial and that people are underinvesting in their schooling. Nevertheless, discussion of education suggests that people don’t fully appreciate everything they’re giving up by spending 4+ years of their life in school. In class, we mentioned the idea of opportunity cost as what one gives up in a course of action — and said it often included both explicit costs and implicit costs. What’s an example of an explicit cost of going to college? What’s an example of an implicit cost of going to college? (6 pts.)
3. Below you have a table showing the marginal benefit and marginal cost of various amounts of tacos. The marginal benefit of each taco is a measure of what you gain from having each additional taco. The marginal cost is what you have to give up to have each additional taco. How many tacos should you buy? Explain. (3 pts.)
Tacos 1 2 3 4 5
$6 $5 $4 $3 $2
$3.75 $3.75 $3.75 $3.75 $3.75
Part II: Analyzing the PPF Model (38 pts.)
5. Consider the following combinations of Petroleum and Coffee for the fictional, two-good economy of Kolombia. Draw Kolombia’s corresponding PPF. Include labels for points A through E. (4 pts.)
6. Circle the right words to complete the sentence. (12 pts.)
a. Suppose the economy of Kolombia was producing 3 gallons of Petroleum and 11 bags of Coffee. This level of production is (attainable, unattainable) and (efficient, inefficient).
b. Suppose the economy of Kolombia was producing 7 gallons of Petroleum and 10 bags of Coffee. This level of production is (attainable, unattainable) and (efficient, inefficient).
Remember: The fact that some production levels are infeasible illustrates the idea of scarcity.
c. “The cost of Petroleum increases as Petroleum production increases” is a (positive, normative) statement, because it describes the economy, rather than making a prescription for how it should be.
d. “Kolombia should invest more in coffee because the poor deserve more jobs.” is a (positive, normative) statement, because it prescribes how the economy should operate, rather than merely describing how the economy does operate.
7. Consider the opportunity cost of increasing the production of coffee by one bag. (10 pts.)
a. What’s the opportunity cost of producing one more bag within the range of B to C? Show your work.
b. What’s the opportunity cost of producing one more bag within the range of C to D? Show your work.
8. The PPF is bowed outward. The underlying reason for this is the principle of increasing costs. What is the principle of increasing costs and what is the reasoning behind it? Explain. (6 pts.)
9. Suppose Kolombia experiences economic growth. Add a second curve to the PPF graph illustrating what happens when economic growth occurs. Include arrows to help differentiate the two curves. (2 pts.)
10. What are the two causes of economic growth within the PPF model? (4 pts.)
Side Notes: If interested, you can check out the website tradingeconomics.com to learn about Colombia’s production in various industries over time. They have tons of fun data to explore– and interesting findings are an exciting opportunity to discover new things and dig deeper into what’s going on in the world.
The global economy has experienced massive growth in the past few hundred years– but at different rates around the world. Look up anything by Max Roser to see data on these changes. Understanding how and why this growth occurred is one of the most fascinating subjects you can study (in my opinion). Talk with me (Mike) if interested in receiving book/article recommendations.
Part III: Supply & Demand (37 pts.)
11. Consider the market for brownies in an economy with two people, Zoe and Joe. Individual demand schedules for Zoe and Joe are provided below. Draw the market demand curve for this economy. Label the axes and clearly include the 3 points on the curve. (4 pts.)
12. Suppose there are two brownie companies in this economy– Gorilla Deli and Bangor Brownies– with individual supply schedules as presented below. On the same graph above, draw the market supply curve . (4 pts.)
13. (6 pts.) a. The Law of Demand states that:
b. The Law of Supply states that:
c. What is the equilibrium price and quantity?
Equilibrium Price = _____ Equilibrium Quantity = _____
14. (8 pts.) a. Suppose the price is $1. What will be the quantity supplied and what will be the quantity
Quantity Supplied = _____ Quantity Demanded = _____
b. Since quantity supplied is (less than, greater than) quantity demanded, there is a (shortage, surplus).
Remember: When Quantity Supplied is less than Quantity Demanded, there is a shortage. When there’s a shortage, producers can raise their prices and sell more– increasing their profit levels. Thus, producers in pursuit of their own self-interest will raise prices and produce more. At the higher prices, consumers will demand a lower quantity. This process continue until the price is at the equilibrium price, where quantity supplied equals quantity demanded.
c. Suppose the price is $3. What will be the quantity supplied and what will be the quantity demanded?
Quantity Supplied = _____ Quantity Demanded = _____
d. Since quantity supplied is (less than, greater than) quantity demanded, there is a (shortage, surplus).
Remember: When Quantity Supplied exceeds Quantity Demanded, there is a surplus. When there’s a surplus, producers in pursuit of their own self-interest will lower their prices in order to sell their goods. In the future, they’ll produce less, because at the lower price it’s not worth it to produce that same amount of goods. Thus, prices will lower until quantity supplied equals quantity demanded.