Limits, Alternatives, and Choices

ANSWERS TO END-OF-CHAPTER AND APPENDIX QUESTIONS

1-1 What is an opportunity cost? How does the idea relate to the definition of economics? Which of the following decisions would entail the greatest opportunity cost: Allocating a square block in the heart of New York City for a surface parking lot or allocating a square block at the edge of a typical suburb for such a lot? Explain. An opportunity cost is what was sacrificed to do or acquire something else. The condition of scarcity creates opportunity cost. If there was no scarcity, there would be no need to sacrifice one thing to acquire another. The opportunity cost would be much higher in New York City as the alternative uses for that square block are much more valuable than for a typical suburban city block. What is meant by the term utility and how does it relate to purposeful behavior? Utility refers to the pleasure, happiness, or satisfaction gained from engaging in an activity (eating a meal, attending a ball game, etc.). It is an important component of purposeful behavior because people will allocate their scarce time, energy, and money in an attempt to gain the most utility possible. (Key Question) Cite three examples of recent decisions that you made in which you, at least implicitly, weighed marginal costs and marginal benefits. Student answers will vary, but may include the decision to come to class, to skip breakfast to get a few extra minutes of sleep, to attend college, or to make a purchase. Marginal benefits of attending class may include the acquisition of knowledge, participation in discussion, and better preparation for an upcoming examination. Marginal costs may include lost opportunities for sleep, meals, or studying for other classes. In evaluating the discussion of marginal benefits and marginal costs, be careful to watch for sunk costs offered as a rationale for marginal decisions. What are the key elements of the scientific method and how does this method relate to economic principles and laws? The key elements include the gathering of data (observation), the formulation of possible explanations (hypothesis), testing the hypothesis, determining the validity of the hypothesis, and repeated testing of hypotheses that have appeared to be valid in prior tests. The scientific method is the technique used by economists to determine economic laws or principles. These laws or principles are formulated to explain and/or predict behavior of individuals or institutions. Indicate whether each of the following statements applies to microeconomics or macroeconomics: a. The unemployment rate in the United States was 5.2 percent in January 2005. b. A U.S. software firm discharged 15 workers last month and transferred the work to India. c. An unexpected freeze in central Florida reduced the citrus crop and caused the price of oranges to rise. d. U.S. output, adjusted for inflation, grew by 4.4 percent in 2004. e. Last week Wells Fargo Bank lowered its interest rate on business loans by one-half of 1 percentage point. f. The consumer price index rose by 2.7 percent in 2004. Macroeconomics: (a), (d), and (f) Microeconomics: (b), (c), and (e) State (a) a positive economic statement of your choice, and then (b) a normative economic statement relating to your first statement.

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Limits, Alternatives, and Choices Student answers will vary. Example: (a) The unemployment rate is 4.8 percent; (b) the unemployment rate is too high. In general we treat what is statements as positive, what should be as normative, but keep an eye out for statements like at full employment an increase in the production of pizzas should come at the cost of less robots. Some students may incorrectly identify the statement as normative because of the term should. (Key Question) Suppose you won $15 on a lotto ticket at the local 7-Eleven and decided to spend all the winnings on candy bars and bags of peanuts. The price of candy bars is $.75 and the price of peanuts is $1.50. a. Construct a table showing the alternative combinations of the two products that are available. b. Plot the data in your able as a budget line in a graph. What is the slope of the budget line? What is the opportunity cost of one more candy bar? Of one more bag of peanuts? Do these opportunity costs rise, fall, or remain constant as each additional unit of the product is purchased. c. How, in general, would you decide which of the available combinations of candy bars and bags of peanuts to buy? d. Suppose that you had won $30 on your ticket, not $15. Show the $30 budget line in your diagram. Why would this budget line be preferable to the old one? (a)
Goods Candy bars Bags of peanuts A 0 10

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Consumption alternatives
B 4 8 C 8 6 D 12 4 E 16 2 F 20 0

(b)

Bags of Peanuts

Slope =

.75 = .5 1.5

10

20

Candy Bars

The slope for the budget line above, with candy bars on the horizontal axis, is -0.5 (= Pcb/Pbp). Note that the figure could also be drawn with bags of peanuts on the horizontal axis. The slope of that budget line would be -2.

Limits, Alternatives, and Choices The opportunity cost of one more candy bar is of a bag of peanuts. The opportunity cost of one more bag of peanuts is 2 candy bars. These opportunity costs are constant. They can be found by comparing any two of the consumption alternatives for the two goods. (c) The decision of how much of each to buy would involve weighing the marginal benefits and marginal costs of the various alternatives. If, for example, the marginal benefits of moving from alternative C to alternative D are greater than the marginal costs, then this consumer should move to D (and then compare again with E, and so forth, until MB=MC is attained).

Limits, Alternatives, and Choices (d)

B ags of P eanuts Incom e = $15

20

10

Income = $30

20

40

Candy Bars

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The budget line at $30 would be preferable because it would allow greater consumption of both goods. What are economic resources? What categories do economists use to classify them? Why are resources also called factors of production? Why are they called inputs? Economic resources are the natural, human, and manufactured inputs used to produce goods and services. Economic resources fall into four main categories: labor, land (natural resources), real capital (machines, factories, buildings, etc.,) and entrepreneurs. Economic resources are also called factors of production because they are used to produce goods and services. They are called inputs because they go in to a production process (like ingredients go into a bowl to make a cake), with the resulting goods and services also being referred to as output. Why isnt money considered a capital resource in economics? Why is entrepreneurial ability considered a category of economic resources, distinct from labor? What are the major functions of the entrepreneur? Money is not considered a capital resource because money is not productive it provides access to resources but itself does not directly contribute to the production of goods and services. Additionally, the quantity of money in circulation does not determine an economys productive capacity, while the amount of capital and other resources does. Doubling the amount of money in circulation does not change the economys physical capacity to produce goods and services. Money is, however, referred as a financial resource and financial capital, reflecting its ability to acquire real economic resources. Entrepreneurial ability and labor are both human resources, but they perform different functions in the productive process. Entrepreneurial ability does not directly produce goods and services; it organizes the resources that do. Labor refers to the human inputs that directly engage in production. Entrepreneurs are risk-takers: They coordinate the activities of the other three inputs for profit or loss, which is why they are called risk-takers. Entrepreneurs sometimes manage companies that they own, but a manager who is not an owner is not necessarily an entrepreneur but may be performing some of the entrepreneurial functions for the company. Entrepreneurs are also innovators, or perhaps inventors, and profits help to motivate such activities.

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Limits, Alternatives, and Choices

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(Key Question) Below is a production possibilities table for consumer goods (automobiles) and capital goods (forklifts):
Type of Production Production Alternatives A Automobiles Forklifts 0 30 B 2 27 C 4 21 D 6 12 E 8 0

a. Show these data graphically. Upon what specific assumptions is this production possibilities curve based? b. If the economy is at point C, what is the cost of one more automobile? Of one more forklift? Explain how the production possibilities curve reflects the law of increasing opportunity costs. c. If the economy characterized by this production possibilities table and curve were producing 3 automobiles and 20 fork lifts, what could you conclude about its use of available resources? d. What would production at a point outside the production possibilities curve indicate? What must occur before the economy can attain such a level of production? (a) See curve EDCBA. The assumptions are full employment, fixed supplies of resources, fixed technology and two goods.

Forklifts

(b) 4.5 forklifts; .33 automobiles, as determined from the table. Increasing opportunity costs are reflected in the concave-from-the-origin shape of the curve. This means the economy must give up larger and larger amounts of rockets to get constant added amounts of automobiles and vice versa.

Limits, Alternatives, and Choices (c) The economy is underutilizing its available resources. The assumption of full employment has been violated. (d) Production outside the curve cannot occur (consumption outside the curve could occur through foreign trade). To produce beyond the current production possibilities curve this economy must realize an increase in its available resources and/or technology. . 1-11 (Key Question) Specify and explain the typical shapes of the marginal-benefit and marginal-cost curves. How are these curves used to determine the optimal allocation of resources to a particular product. If current output is such that marginal cost exceeds marginal benefit, should more or fewer resources be allocated to this product? Explain. The marginal benefit curve is downward sloping, MB falls as more of a product is consumed because additional units of a good yield less satisfaction than previous units. The marginal cost curve is upward sloping, MC increases as more of a product is produced since additional units require the use of increasingly unsuitable resource. The optimal amount of a particular product occurs where MB equals MC. If MC exceeds MB, fewer resources should be allocated to this use. The resources are more valuable in some alternative use (as reflected in the higher MC) than in this use (as reflected in the lower MB). Explain how (if at all) each of the following affects the location of a countrys production possibilities curve: a. The quality of education increases. b. The number of unemployed workers increases. c. A new technique improves the efficiency of extracting copper from ore. d. A devastating earthquake destroys numerous production facilities. (a) Assuming better education translates into better work skills, then productivity should rise and this would shift the curve outward. (b) Should not affect location of curve. Production moves inward, away from the curve. (c) The curve should shift outward as more production is possible with existing resources. (d) The curve should shift inward with the destruction of resources (capital). (Key Question) Referring to the table in question 10, suppose improvement occurs in the technology of producing forklifts but not in the technology of producing automobiles. Draw the new production possibilities curve. Now assume that a technological advance occurs in producing automobiles but not in producing forklifts. Draw the new production possibilities curve. Now draw a production possibilities curve that reflects technological improvement in the production of both products. See the graph for question 1-10. PPC1 shows improved forklift technology. PPC2 shows improved auto technology. PPC3 shows improved technology in producing both products. (Key Question) On average, households in China save 40 percent of their annual income each year, whereas households in the United States save less than 5 percent. Production possibilities are growing at roughly 9 percent annually in China and 3.5 percent in the United States. Use graphical analysis of present goods versus future goods to explain the differences in growth rates.

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Limits, Alternatives, and Choices

United States Future Goo ds Future Goods

China

B A Present Goods
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Suppose that, on the basis of a nations production possibilities curve, an economy must sacrifice 10,000 pizzas domestically to get the 1 additional industrial robot it desires, but that it can get the robot from another country in exchange for 9,000 pizzas. Relate this information to the following statement: Through international specialization and trade, a nation can reduce its opportunity cost of obtaining goods and thus move outside its production possibilities curve. The message of the production possibilities curve is that an individual nation is limited to the combinations of output indicated by its production possibilities curve. International specialization means directing domestic resources to output which a nation is highly efficient at producing. International trade involves the exchange of these goods for goods produced abroad. Specialization and trade have the same effect as having more and better resources or discovering improved production techniques. The output gains from greater international specialization and trade are the equivalent of economic growth. (Last Word) Studies indicate that married men on average earn more income than unmarried men of the same age and education level. Why must we be cautious in concluding that marriage is the cause and higher income is the effect? Correlation does not necessarily mean that there is causation. The relationship could be purely coincidental or dependent on some other factor not included in the analysis. It is also possible that higher income is the variable that causes marriage.

Chapter 1 - Appendix 1A-1 Briefly explain the use of graphs as a way to present economic relationships. What is an inverse relationship? How does it graph? What is a direct relationship? How does it graph? Graph and explain the relationships you would expect to find between (a) the number of inches of rainfall per month and the sale of umbrellas, (b) the amount of tuition and the level of enrollment at a university, and (c) the popularity of an entertainer and the price of her concert tickets. In each case cite and explain how variables other than those specifically mentioned might upset the expected relationship. Is your graph in part b, above, consistent with the fact that, historically, enrollments and tuition have both increased? If not, explain any difference. Graphs can be used to illustrate the relationship between two sets of data. An inverse relationship is when the two variables change in opposite directions. The line is downward sloping. A direct relationship is when the two variables change in the same direction. The line is upward sloping.

Limits, Alternatives, and Choices Statements (a) and (c) illustrate direct relationships. Statement (b) illustrates an inverse relationship. The inverse relationship is assuming that everything else remains equal. (Key Appendix Question) Indicate how each of the following might affect the data shown in the table and graph in Figure 2 of this appendix: a. GSUs athletic director schedules higher-quality opponents. b. An NBA team locates in the city where GSU plays. c. GSU contracts to have all its home games televised. (a) More tickets are bought at each price; the line shifts to the right. (b) Fewer tickets are bought at each price, the line shifts to the left. (c) Fewer tickets are bought at each price, the line shifts to the left. (Key Appendix Question) The following table contains data on the relationship between saving and income. Rearrange these data into a meaningful order and graph them on the accompanying grid. What is the slope of the line? The vertical intercept? Interpret the meaning of both the slope and the intercept. Write the equation which represents this line. What would you predict saving to be at the $12,500 level of income?

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Income (per year)` $15,000 0 10,000 5,000 20,000

Saving (per year) $1,000 -500 500 0 1,500

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Income column: $0; $5,000; $10,000, $15,000; $20,000. Saving column: $-500; 0; $500; $1,000; $1,500. Slope = 0.1 (= $1,000 - $500)/($15,000 - $10,000). Vertical intercept = $-500. The slope shows the amount saving will increase for every $1 increase in income; the intercept shows the amount of saving (dissaving) occurring when income is zero. Equation: S = $-500 + 0.1Y (where S is saving and Y is income). Saving will be $750 at the $12,500 income level. Construct a table from the following data shown on the accompanying graph. Which is the dependent variable and which the independent variable? Summarize the data in equation form.

Limits, Alternatives, and Choices

Study time (hours) 0 2 4 6 8 9

Exam scores 10 30 50 70 90 100

The dependent variable (the effect) is the exam score and the independent variable (the cause) is the study time.

The equation is: Exam score = 10 + (50 30 ) / (4 2 ) Study time

= 10 + 20 / 2 Study time = 10 + 10 Study time

Proof: Exam score when study time is 6 hours: = 10 + (10 6)

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= 10 + 60 = 70 as shown in the table above Suppose that when the interest rate on loans is 16 percent, businesses find it unprofitable to invest in machinery and equipment. However, when the interest rate is 14 percent, $5 billion worth of investment is profitable. At 12 percent interest, a total of $10 billion of investment is profitable. Similarly, total investment increases by $5 billion for each successive 2-percentage point decline in the interest rate. Describe the relevant relationship between the interest rate and investment in words, in a table, graphically, and as an equation. Put the interest rate on the vertical axis and

Limits, Alternatives, and Choices

investment on the horizontal axis, and in your equation use the form i = a + bI, where i is the interest rate, a is the vertical intercept, b is the slope of the line (which is negative), and I is the level of investment. Comment on the advantages and disadvantages of the verbal, tabular, graphic, and equation forms of description.
Interest rate (in percent) 16 14 12 10 8 6 4 2 0 Amount of investment (billions of dollars) $ 0 5 10 15 20 25 30 35 40

I = 16 [(16 14 ) / (5 0)] I = 16 2 / 5I Proof: substituting data from the table when I is $25 billion, i = 16 -2/5(25) = 16 - 10 = 6 The verbal presentation can be made, but is hard to visualize. The tabular presentation is precise; all the facts are there, neatly arrayed, and it is easier to visualize than the verbal one. The graphic presentation shows at a glance the relationship between the variables and, moreover, is best for showing large changes, that is, movements of a whole curve. However, the graph requires careful drafting to ensure that it is as accurate as the table. The equation is as precise as the table and, moreover, describes all the intermediate points not set out in the table. For most people, though, the equation form is probably the hardest to visualize.

When the interest rate is 16%, investment spending will be zero. When the interest rate is 14%, investment spending will be $5 billion. For each successive drop of 2 percentage points in the interest rate, investment spending will increase by $5 billion. Using equation I = a bI

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Su uppose that C = a + bY, where C = c consumption, a = consump ption at zero income, b= s slope, an Y = incom nd me. a. Are C and Y positively related or are they negativ related? . e vely b. If graphed, would the cu . urve for this e equation slop upward or d pe downward? c. Are the va . ariables C and Y inversely r d related or dire ectly related? d. What is the value of C i a =10, b =.5 and Y = 200? . if 50, e. What is the value of Y i C = 100, a = 10, and b = .25? . if (a C and Y ar positively r a) re related. (b The curve would slope upward. b) (c C and Y ar directly rel c) re lated. (d C = 110. d) (e Y = 360. e)

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Limits, Alternatives, and Choices

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(Key Appendix Question) The accompanying graph shows curve XX and tangents at points A, B, and C. Calculate the slope of the curve at these three points.

Slopes: at A = +4; at B = 0; at C = -4. 1A-8 In the accompanying graph, is the slope of curve AA positive or negative? Does the slope increase or decrease as we move along the curve from A to A? Answer the same two questions for curve BB. Slope of AA is positive (rising from left to right). The slope increases as we move from A to A. Slope of BB is negative (dropping from left to right). The slope increases as we move from B to B. The slopes of both curves are tending to infinity as they continue to move to the right.

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