Problem Set 1: Key

Problem Set 1: Answer Key

1.	If you spend $100 now instead of investing it for a year and earning 5 percent interest, you are giving up the opportunity to spend $105 a year from now. This idea, that money has a time value, is the basis for the entire field of finance, the subfield of economics that has to do with prices of financial instruments like stocks and bonds.

2.	a.	The minimum opportunity cost is $3,000 of direct expenses + a $26,000 of foregone earnings for a total of $29,000.
	b.	No. The parent's choice of part-time plus volunteer work implies a sacrifice of a $26,000 full-time job, so the $4,000 of part-time income + the value of the intangible benefits of the job and the volunteer work must equal at least that much. Answer key checklist: Did you notice that the parent does give up the part-time plus volunteer work once the child is born, so the cost is 3K + 4K + value of volunteer work (22K+)?

3.	a.	See diagram to right. Benefits of college = CDE (extra earnings) Costs of college = AB, where A=direct expenses B=foregone income Answer key checklist: The dollar values you plot for each year should equal the dollars for that year only.
	b.	D=college income benefits lost by leaving workforce for 15 years (note that F is lost whether you go to college or not.
	c.	Since women are less likely to leave the labor force for long periods of time now, the net benefits of college have gone up, so they are more likely to pursue a college degree.

4.	a.	Economic costs are not the same. Foregone earnings are lower for women ($21,711<$33,506).
	b.	Economic benefits are not the same. Extra earnings from a college degree are higher for men: 59,079-33,506=25,573 > 39,571-21,711=17,860. (Note: In percentage terms, earnings increase 90% for men and 80% for women, still larger for men but a smaller gap. The percentage increase better reflects the "rate of return" on the "invested" foregone income.) Answer key checklist: Did you remember to compare high school wages to college wages to calculate the benefit of having a college degree?

5.	a.	The statement that society faces a short-run tradeoff between inflation and unemployment is a positive statement. It deals with how the economy is, not how it should be. Since economists have examined data and found that there's a short-run negative relationship between inflation and unemployment, the statement is a fact, thus it's a positive statement.
	b.	The statement that a reduction in the rate of growth of money will reduce the rate of inflation is a positive statement. Economists have found that money growth and inflation are very closely related. The statement thus tells how the world is, and so it is a positive statement.
	c.	The statement that the Federal Reserve should reduce the rate of growth of money is a normative statement. It states an opinion about something that should be done, not how the world is.
	d.	The statement that society ought to require welfare recipients to look for jobs is a normative statement. It doesn't state a fact about how the world is. Instead, it is a statement of how the world should be and is thus a normative statement.
	e.	The statement that lower tax rates encourage more work and more saving is a positive statement. Economists have studied the relationship between tax rates and work, as well as the relationship between tax rates and saving. They've found a negative relationship in both cases. So the statement reflects how the world is, and is thus a positive statement.

6.	a.	See diagram to right.
	b.	See diagram to right
	c.	Cost = spirit foregone: unit 3: opp.cost = 36-26=10 unit 4: opp.cost = 26-14=12 Answer key checklist: Did you calculate opportunity cost as the spirit lost for each specified unit of flesh? (Example: to get unit 3, spirit output falls from 36 to 26, an opp.cost of 10 units of spirit)
	d.	(1) Unemployment --> production inside the PPF (2) Change in technology shifts the PPF (but production of "Flesh" still has a maximum of 5 since "Flesh" technology didn't change) (3) Discrimination => inefficiency --> production inside the PPF. Answer key checklist: (1) Did you draw a new PPF only for event 2? (2) Did you show a point inside the original PPF for events 1 and 3?

7.	a.	(1) choose C=3, I=8 to grow as rapidly as possible. (2) choose C=8, I=2 to consume as much as possible. (3) choose anywhere within the range of C=3 to 8 and I=2 to 8 to grow without starving.
	b.	After drought PPC goes through C=3, I=2, so only that point should be chosen in all 3 cases.

8.	a.	A fall in the price of flour. (1) bagel market: S shifts right/down due to lower input price --> lower price and higher quantity. (2) cream cheese market: D shifts right due to lower price of a complement --> higher price and quantity
	b.	A rise in the price of milk: (1) cream cheese market: S shifts left/up due to higher input price higher price and lower quantity (2) bagel market: D shifts left due to higher price of a complement --> lower price and lower quantity.
	Answer key checklist: (1) Did you draw a separate S&D diagram for each market (bagels and cream cheese)? (2) Did you shift only one curve in each market?

9.	See diagrams below.

	a.	Disease: S shifts left: P rises, Q falls
	b.	Lower Pcomp: D shifts right: P rises, Q rises
	c.	Higher Psub: D shifts right: P rises, Q rises
	d.	Health fears: (1) D shifts left: P falls, Q falls Higher feed costs:(2) S shifts left/up: P rises, Q falls Combined: P: ?, Q falls Answer key checklist: Did you note that P changes in an uncertain direction since the two events push P in opposite directions?
	e.	Tech.improvement: S shifts right: P falls, Q rises
	f.	Tax: S shifts up: P rises, Q falls. (Similar to d2 above.) P rises < $1--S shifts up by $1, but excess supply at the original quanity pushes price down to a new equilibrium that is less than $1 higher than the original equilibrium. Answer key checklist: For a,d and e, did you shift supply in the correct direction in each case?

10.	A temporarily high birth rate in the year 2010 leads to opposite effects on the price of babysitting services in the years 2015 and 2025. In the year 2015, there are more 5-year olds who need sitters, so the demand for babysitting services shifts right. The result is a higher price for babysitting services in 2015. However, in the year 2025, the increased number of 15-year olds shifts the supply of babysitting services to the right. The result is a decline in the price of babysitting services. Note: in diagrams: 2005 s/b 2015 and 2015 s/b 2025.

11.	See diagram to right August: Price of complement fell, so D shifted right. Result: P rises, Q rises. September: (1) Price of complement rose back, so D shifted back left again. (2) Input prices rose, so S shifted up. Result: P rises and Q falls from its initial equilibrium.

12	(1)	The price has risen, and the equilibrium quantity has risen too.
	(2)	a.	Yes, their fears were consistent with the law of demand, since they expected quantity demanded to fall with a rise in price.
		b.	Demand shifted right because of higher soda prices, lower drinking age, and warm weather. Answer key checklist: Did you make it clear that consumption didn't fall because demand had shifted to the right (in other words, the "other things being equal" condition necessary for the law of demand didn't hold here).
		See diagram to right.
	(3)	a.	Not consistent: S shifts left with higher input prices, so price should rise, but quantity should fall, not rise.
		b.	Consistent: higher substitute prices shift beer demand right.
		c.	Consistent: size of market has grown, so demand shifts right.
		d.	Consistent: warm weather is an event of nature which shifts beer demand right.

13.	1.	Draw diagram. Sugar is an input in the production of moonshine. An increase in the price of an input shifts the supply curve to the left.
	2.	Draw diagram. Legal whiskey and moonshine are substitutes. An increase in the price of moonshine should shift the demand for legal whiskey to the right.