P [$]

Economics 101
Homework #3
Fall 2009
Answer Key
1. International Trade
Consider the market for books. Domestic demand for books in a small country is given by
the equation P= -3Qd+ !!. Domestic su""ly is given by the equation P=Qs. #he $orld
"rice of books is %!.
a. &ssume that this economy is closed to $orld trade. Calculate the equilibrium quantity'
"rice' consumer sur"lus' and "roducer sur"lus in the market for books.
Answer:
If this economy is closed to world trade, the equilibrium quantity is 25 and the price is
$25 !he consumer surplus is "#$2%&25&"#''(25%) $*+,5 !he producer surplus is
"#$2%&25&25) $+#25
b. (o$ assume that this economy o"ens to $orld trade. )o$ many units of books $ill
this economy im"ort or e*"ort+ Calculate the equilibrium quantity' "rice' consumer
sur"lus' "roducer sur"lus' and total sur"lus in the market for books if this economy
o"ens to trade. ,s there a dead$eight loss $hen this economy o"ens to trade+
Answer:
!he world price is lower than the equilibrium price, so we -now that this country will
import boo-s At a price of $#', consumers want to buy +' units and domestic suppliers
want to sell #' units !hus, the country will import 2' units .onsumer surplus equals
"#$2%&+'&"#''(#'%) $#+5' Producer surplus equals "#$2%&#'&#') $5' /eadwei0ht loss
is $' !he total surplus is equal to $#1''
/
2
3
25

.3
P3
25
#''
c. Continue to assume that this economy is o"en to $orld trade' but no$ the government
has im"osed a tariff of %- "er book. Calculate the ne$ equilibrium quantity' "rice'
consumer sur"lus' "roducer sur"lus' and the dead$eight loss in the market for books
$hen this economy im"oses this tariff.
Answer:
!his tariff raises the effecti4e world price to $#* At this price, consumers demand 2,
boo-s, and domestic suppliers are willin0 to sell #* boo-s !hus, 5 boo-s are imported
.onsumer surplus equals "#$2%&2,&"#''(#*% ) $#'*+5, and producer surplus equals
"#$2%&#*&#*) $#5'5 6o4ernment7s tariff re4enue is 5&*)$,2 !hus, total welfare, which
is consumer surplus plus producer surplus plus 0o4ernment re4enue, equals $#,+18 In
part "b%, total surplus equaled consumer surplus plus producer surplus, which is equal to
$#1'' !hus the deadwei0ht loss, which is the lost welfare, equals #1''(#+18) $51
/
2
3
#' 25

+'
25
#''
#'
/
2
3
#' 25

+'
25
#''
#'
#*
#* 2,
d. ,nstead of the tariff' su""ose that the government im"lements a quota of . books.
Calculate the ne$ equilibrium quantity' "rice' consumer sur"lus' "roducer sur"lus' and
the dead$eight loss in the market for books $hen this country im"oses the quota.
Answer:
A quota means that they can only import #2 units After imposin0 a quota of #2, the new
supply cur4e "domestic supply 9 quota% will be the red line !he equation is follows:
P) 2s if 2s :#'
P)#' if #'2s22
P) 2s(#2, if 2s ;22
<or 0ettin0 the new equilibrium, we need to sol4e (+2d9 #'') 2s(#2 !herefore the
equilibrium quantity is 2)25, and the equilibrium price is P)#8 At this price, the
quantity demanded by domestic consumers is 25, and the quantity supplied by domestic
suppliers is #8, implyin0 that #2 boo-s "the amount of the quota% are imported
.onsumer surplus equals "#$2%&25&"#''(#8% ) $##,8, and producer surplus equals
"#$2%&#8&#8) $#25 !here is no 0o4ernment re4enue in this case, because there is no ta=
>owe4er, in part "b%, forei0n producers earned $#' for each import ?ow, they are
earnin0 $#8 per import In this case, the license holder re4enue equals "#8(#'%&"25(#8% )
$,2 !hus, total welfare, which is consumer surplus plus producer surplus plus license
holder re4enue, equals $#,+,8 In part "b%, total surplus equaled consumer surplus plus
producer surplus, which is equal to $#1'' !hus, the deadwei0ht loss, which is the lost
welfare, equals #1''(#+,8) $21
e. ,nstead of the quota of . books' su""ose that the government im"lements a quota of
./ books. Com"are the dead$eight loss in the market to that of "art 0d1.
Answer:
/
2
3
#' #8 22 25

+'
25
#''
#'
/omestic supply
92uota
#8
@hen there are no restrictions such as a tariff or a quota, the 2' boo-s are imported "part
"b%% If the quota is 25 boo-s, 2' boo-s can be imported !hus, in this quota e=ample we
0et the same results as we found with the open economy without any restrictions "part
"b%% As we calculated in part "b%, the deadwei0ht loss is $' !herefore, the deadwei0ht
loss of "e% is less than the deadwei0ht loss of "d%
f. ,f the $orld "rice of books equaled %3 instead of %!' ho$ many units $ould this
country im"ort or e*"ort+ Calculate the ne$ equilibrium quantity' "rice' consumer
sur"lus' and "roducer sur"lus.
Answer:
3ince the world price "$+#% is hi0her than the domestic equilibrium price "$25%, the
domestic sellers in the economy will e=port boo-s At a price of $+#, consumers want to
buy 2+ units and domestic suppliers want to sell +# units !hus, the country will e=port 5
units .onsumer surplus equals "#$2%&2+&"#''(+#%) $,*+5 Producer surplus equals
"#$2%&+#&+#) $15'5
/
2
3
#'

+' +5
25
#''
#'
/omestic supply
92uota
/
2
3
2+ 25

+#
25
#''
+#
2. Elasticity
Consider the market for bicycles. #he demand is given by P= -./Qd+ 2!.
a. 3u""ose that the "rice changes from %/ to %3!. 4sing the standard "ercentage
change formula 0not the mid"oint method1' $hat is the "rice elasticity of demand+
Answer:
Asin0 the demand equation, we can 0et 2d )+' when P)#5, and 2d )2' when P)+'
b. 3u""ose that the "rice changes from %3! to %/. 4sing the mid"oint method' $hat is
the "rice elasticity of demand+
Answer:
c. 5hen P=/' $hat is the "rice elasticity of demand' using the "oint elasticity of
demand+ ,s it elastic or inelastic+ &t P=/' if the "rice goes u"' does the total revenue
increase' decrease' or stay the same+
Answer:
Asin0 the demand equation, we can 0et 2d )+', when P)#5
3ince ep ) #$+ :#, the demand is inelastic !herefore, when the price 0oes up, the total
re4enue increases
d. 5hen Qd =!' $hat is the "rice elasticity of demand' using the "oint elasticity of
demand+ ,s it elastic or inelastic+ &t Qd =!' if the "rice goes u"' does the total revenue
increase' decrease' or stay the same+
Answer:
Asin0 the demand equation, we can 0et P)15, when 2d )#'
3ince ep ) + ;#, the demand is elastic !herefore, when the price 0oes up, the total
re4enue decreases
e. &t $hat "rice is the "rice elasticity of demand equal to +
Answer:
!he unit elastic point occurs at the midpoint of the demand cur4e if the demand cur4e is
linear and intersects both the y(a=is and =(a=is
@hen we draw the demand cur4e, the y(intercept is 8', and the =(intercept is 1'
!herefore, the midpoint of the demand cur4e is "2', +'%, which is the unit(elastic point
!he answer is P)+'
f. 3u""ose you are a "roducer of bicycles. #o ma*imi6e total revenue' at $hat "rice
should you sell bicycles+ )o$ much is the ma*imi6ed total revenue+
Answer:
At the midpoint which is the unit elastic point, the total re4enue will be ma=imiBed
!herefore, P)+', and !otal Ce4enue) +'&2')8'' "the rectan0le shaded in the abo4e
0raph%
3. Real s. !ominal "rice
7ou are given the follo$ing information about "roduction in 5onderland.
Item "rice
in 200#
$%antity
in 200#
"rice
in 200&
$%antity
in 200&
"rince
in 2009
$%antity
in 2009
Da0el 2 5 2 5 2 5
PiBBa #5 1 #5 + 2' 2
Ears of .orn 5 + 1 5 1 ,
Danana # #' 2 #' # #2
8or "ur"oses of com"uting the CP, you are told that the market basket consists of /
bagels' 3 "i66as' / ears of corn' and ! bananas.
a. Calculate the CP, for .!!9' .!!:' and .!!- using .!!: as the base year. 4se a !!
"oint scale for your CP, measure. 3ho$ your $ork.
60
40
P
Q
Midpoint (20, 30)
Answer:
.ost of mar-et bas-et in 2'', ) 2&5 9 #5&+ 9 5&5 9 #&#' ) *'
.ost of mar-et bas-et in 2''5 ) 2&5 9 #5&+ 9 1&5 9 2&#' ) #'1
.ost of mar-et bas-et in 2''* ) 2&5 9 2'&+ 9 1&5 9 #&#' ) #''
.PI in 2'', ) [.ost of mar-et bas-et in 2'',$.ost of mar-et bas-et in base year]&#''
.PI in 2'', ) "*'$#'1%&#'' ) 5851
.PI in 2''5 ) [.ost of mar-et bas-et in 2''5$.ost of mar-et bas-et in base year]&#''
.PI in 2''5 ) "#'1$#'1%&#'' ) #''
.PI in 2''* ) [.ost of mar-et bas-et in 2''*$.ost of mar-et bas-et in base year]&#''
.PI in 2''* ) "#''$#'1%&#'' ) *8#5
b. Calculate the rate of inflation bet$een .!!9 and .!!:' and the rate of inflation
bet$een .!!: and .!!-' based u"on the above information and using the CP, as your
measure of the "rice level.
Answer:
Cate of inflation between 2'', and 2''5) ["#''F 5851%$5851] & #'' ) #558G "or
#555G%
Cate of inflation between 2''5 and 2''*) ["*8#5F #''%$#''] & #'' ) (+55G
c. )olding everything else constant' recalculate the CP, using .!!- as the base year.
Answer:
.PI in 2'', ) [.ost of mar-et bas-et in 2'',$.ost of mar-et bas-et in base year]&#''
.PI in 2'', ) "*'$#''%&#'' ) *'
.PI in 2''5 ) [.ost of mar-et bas-et in 2''5$.ost of mar-et bas-et in base year]&#''
.PI in 2''5 ) "#'1$#''%&#'' ) #'1
.PI in 2''* ) [.ost of mar-et bas-et in 2''*$.ost of mar-et bas-et in base year]&#''
.PI in 2''* ) "#''$#''%&#'' ) #''
d. ;ased on your calculation in "art 0c1' $hat is the rate of inflation bet$een .!!9 and
.!!:+ 5hat is the rate of inflation bet$een .!!: and .!!-+
Answer:
Cate of inflation between 2'', and 2''5) ["#'1 F *'%$*'] & #'' ) #558G
Cate of inflation between 2''5 and 2''*) ["#'' F #'1%$#'1] & #'' ) (+55G
e. 3u""ose you live in the economy de"icted in the above information and your nominal
salary in .!!9 is %:'!!! a year. 7our boss tells you she is going to increase your
nominal salary to %.!'!!! in .!!:. ;ased on your calculation in "art 0c1 and 0d1' $ill
this nominal increase in salary increase your "urchasing "o$er or decrease your
"urchasing "o$er+ 3ho$ your $ork.
Answer:
.PI in 2'', ) *', .PI in 2''5 ) #'1
Asin0 2'', as a base year, the real salary in 2'', is $#5,''' "same with the nominal
salary in 2'',% Asin0 2'', as a base year, the real salary in 2''5 can be calculated as
follows:
!he real salary in 2''5 is lower than the real salary in 2'', !herefore, the purchasin0
power "real salary% decreases, e4en if the nominal salary increases
f. 3u""ose your nominal salary $as %.!'!!! in .!!:. ;ased on your calculation in "art
0c1 and 0d1' $hat<s the minimum nominal salary you should ask for .!!- in order to
maintain the same real salary="urchasing "o$er you had in .!!:+
Answer:
.PI in 2''5 ) #'1, .PI in 2''* ) #''
Asin0 2''5 as a base year, the Ceal salary in 2''5 is $2',''' ?ominal salary in 2''* for
maintainin0 the real salary of $2',''' can be calculated as follows:
,,
!herefore, I should as- $#*,2+',, for 2''* to maintain the same purchasin0 power I had
in 2''5
'. (%d)et set
3u""ose (oah<s available income to s"end on >eans and shirts is %!!. 8urthermore'
su""ose the "rice of >eans is %/! "er "air of >eans and the "rice of shirts is %! "er shirt.
a. Dra$ (oah<s budget line on a gra"h. ?easure >eans on the *-a*is and shirts on the y-
a*is. @abel your gra"h carefully and include the numerical values of the y-interce"t and
*-interce"t.
Answer:
#'&3hirts 9 5'&Heans ) #''
3 ) (5 H 9 #'
b. 3u""ose the "rice of shirts doubles $hile the "rice of 3hirts and (oah<s income are
unchanged. Provide an equation in slo"e-interce"t form for the budget line' and dra$
(oah<s budget line on a gra"h.
Answer:
!he new price of 3hirts is #'&2)$2'
2'&3hirts 9 5'&Heans ) #''
3 ) (25 H 9 5
c. (o$' (oah gets a raise in his salary. 3o' (oah<s available income to s"end on >eans
and shirts becomes %.!!. Prices are same as in "art 0b1. Provide an equation in slo"e-
interce"t form for the budget line' and dra$ (oah<s budget line on a gra"h.
Answers:
!he price of shirts is $2', and the price of Ieans is $5' !he new income is $2''
2'&3hirts 9 5'&Heans ) 2''
3 ) (25 H 9 #'
H 2
3
#'
H 2
3
5
d. Prices and ,ncome are same as in "art 0c1. 5hich of the follo$ing combinations of
>eans and shirts can (oah afford+ 0Put a check in the a""ro"riate column for each of the
given combinations.1
*om+ination A,,ord !ot A,,ord
5 shirts, 2 Ieans
2 shirts, + Ieans
5 shirts, # Ieans
# shirts, 5 Ieans
Answer:
!he bud0et constraint is 2'&3hirts 9 5'&Heans 2''
#% 5 shirts, 2 Ieans: 2'&5 9 5'&2 ) 2'' Afford
2% 2 shirts, + Ieans: 2'&2 9 5'&+ ) #*' Afford
+% 5 shirts, # Ieans: 2'&5 9 5'&# ) 2#' ?ot Afford
1% # shirts, 5 Ieans: 2'&# 9 5'&5 ) 2,' ?ot Afford
H 1
3
#'