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Name_____Key____________________________
Fall, Homework 2011
Due: Wednesday, September 7th at the beginning of class.
Directions: I prefer that you print out this document and answer the questions clearly in the
spaces provided. I reserve the right to penalize sloppy or unclear answers.
1.
a. Define opportunity cost.
Opportunity cost is the value of the next-best alternative sacrificed when a
choice is made.
b. Sarahs friends are trying to convince her to leave her summer job one
month early, from which she earns $1200 per month, to vacation in Costa
Rica. If she goes there, her out-of-pocket expenses would be $1500. What is
Sarahs marginal opportunity cost of going to Costa Rica? If the marginal
benefit she gets from the vacation is equivalent to $2500, should she go?
Explain.
Her opportunity cost is the out-of-pocket expenses ($1500) plus the lost
income ($1200), for a total of $2700. She should not go because marginal
benefit < marginal opportunity cost.
c. Now suppose that Sarah has already purchased the plane fare to Costa Rica,
which is $800 of the $1500 trip cost. What is her marginal opportunity cost
of the trip in this case? If her MB is still $2500, what should she do?
Explain.
The plane fare expense is now sunk and doesnt matter (assuming she
cant use the miles for another flight) Her marginal opportunity cost in
this case is the remaining $700 cost of the trip plus the $1200 lost income,
for a total of $1900. Now she should go because Marginal Benefit
>Marginal Opportunity Cost.
2. Suppose HP is currently selling 250,000 laptops per month. A manager at HP
argues, the last 10,000 laptops we produced increased our revenue by $8.5m and
our costs by $8.9m. However, because we are making a substantial total profit of
$25m from producing 250,000 laptops, I think we are producing the optimal number
of laptops. Briefly explain whether you agree with the managers reasoning.
The manager is failing to think at the margin. Dell has lost $400,000 on
the last 10,000 laptops, so their profits would have been higher if they had
not produced them.
3. Steve purchased a motorcycle for $9000 five years ago, and either wants to sell it
today or keep it one more year. If he sells today, hed get $6000 for it, and hed put
the money in a mutual fund for a year earning 10% return. If he keeps it for a year
and then sells it, hed get $5000 for it. What is the marginal opportunity cost of
keeping the motorcycle one more year?
The opportunity cost is the value of the depreciation ($1000) plus the lost
interest income on $6000 (.10(6000)=$600), totaling $1600. The
purchase price plays no part because it is a historical (sunk) cost.
4. Hubbard, Chapter 2, Problem #1.9. In addition to the questions, answer the
following:
a. Use the data in the table to draw a production possibilities frontier graph.
Label the vertical axis Score on Economics Exam and label the horizontal
axis Score on chemistry exam. Make sure label to the values where your
production possibilities frontier intersects the vertical and horizontal axes.
b. Label the points representing choice C and choice D. If you are at choice C,
what is your opportunity cost of increasing your chemistry score?
The opportunity cost of increasing your chemistry score by 4 points in
moving from Choice C to Choice D is the 4 point decline in your
economics score.
c. Under what circumstances would A be a sensible choice?
Choice A might be sensible if the marginal benefits of doing well on the
chemistry exam are low relative to the marginal benefits from doing well
on the economics exam for example, the chemistry exam is only a small
portion of your grade, but the econ exam is a large portion of your grade;
or if your are majoring in economics and dont care much about
chemistry; or if you already have an A sewn up in chemistry, but the econ
professor will replace a low exam grade with this exam grade.
d. Between an economics score of 81 and 86, what is the opportunity cost (on
average) of increasing your economics score by one point? What is it
between an economics score of 93 and 95? As you put more time into
economics, is the opportunity cost of an extra point in economics rising or
falling?
The cost of increasing your economics score from 81 to 86 is a 2 point
reduction in your chemistry score; thus, each additional economics point
in this range has a cost of 2/5 = .4 chemistry points. The cost of increasing
your economics score from 93 to 95 is an 8 point reduction in chemistry,
thus each additional economics score costs 8/2 = 4 chemistry points. The
opportunity cost of additional points in economics is rising as the
economic score increases.
5. Imagine a society that produces military goods (guns) and consumer goods
(butter). Draw a bowed-out (concave) PPF for guns and butter, with guns on the
upper axis. Imagine the society has two political parties, called the Hawks (who
advocate a strong military), and Doves (who want a smaller military). Show a point
on your PPF that the Hawks might choose and a point the Doves might choose. Now
suppose a previously aggressive neighboring country reduces the size of its military.
As a result, both the Hawks and Doves reduce their desired production of guns by
the same amount. Which party would get the bigger peace dividend as measured
by the increase in butter production? Explain
The Hawks might choose a point like H, with many guns and not much
butter. The Doves might choose a point like D, with a lot of butter and
few guns.
If both Hawks and Doves reduced their desired quantity of guns by the
same amount, the Hawks would get a bigger peace dividend because the
production possibilities frontier is much flatter at point H than at point D.
As a result, the reduction of a given number of guns, starting at point H,
leads to a much larger increase in the quantity of butter produced than
when starting at point D.