10010: 1ECON PROBLEM SET No. 1
SOLUTIONS
1. You or your family have probably tried to estimate the cost of going to University:
Suppose Tuition charges and books are 1,000, food and other living expenses are
5,000, you live near the Campus so there are no accommodation or transport costs.
The alternative to University is a job which pays 15,000. What is the opportunity
cost of going to University? How does it differ from your conventional cash budget?
Opportunity Cost is what you give up to go to College: 15,000 in lost earnings plus
1,000 for books, etc; Total 16,000. The 5,000 food and living expenses are not
part of this: you have to eat and live whether or not you go to College. Clearly for
day-to-day cash budgeting the 5,000 is relevant. Accommodation costs could be
tricky, and the question was framed so as to rule them out completely.
2. You have bought a PC for 1,000. Once bought its second-hand value is only
600. You now realise that it was not a good buy, and you would prefer to have 600
to spend on textbooks. You are told not to be stupid, that selling the PC for 600
means virtually throwing away 400. Should you heed the advice? Why? Why not?
Originally you thought (or even calculated) that the PC was worth (in terms of
benefits to you) at least 1,000; otherwise you would not have bought it. Now, you
prefer 600 for books to keeping the PC, which implies that you should sell the PC
for 600 and re-invest the money in books (greater benefit for your 600). The loss
involved in selling the PC for 400 less than you paid for it reflects a mistake which
cannot be undone (i.e. a sunk cost). While in one sense one ought to learn from
mistakes, keeping the PC is persisting in the mistake. The sunk cost of 400, while
regrettable, is irrelevant to the decision at hand. (Learning from mistakes perhaps
implies that you ought to think more carefully in the future when buying a big-ticket
item).
3. Suppose it takes 10 man-hours to produce a bicycle in China and 5 man-hours in
Ireland. Also it takes 50 man-hours to produce a computer in China and 10 manhours in Ireland. In what good does Ireland have a Comparative Advantage? In
which good does China have a Comparative Advantage? Note: the data in this
question is in terms of units of output per unit of input (man-hours), whereas in the
Ireland-France class example they were in terms of number unit of input needed to
produce a unit of output. You should be able to cope with this twist.
In China a bicycle can be produced by 10 man-hours and a computer takes 50. This
implies a trade-off of 5 bicycles per computer, and if China did not trade with anyone,
a computer would trade for the same price as 5 bicycles. In Ireland, given 5 manhours per bicycle and 10 per computer, the trade-off would be 2 bicycles per
computer: a computer would cost the same as 2 bicycles. Computers would be
relatively cheap compared to bicycles in Ireland, which is the same as saying that
bicycles are relatively cheap compared to computers in China. China has a
Comparative Advantage in bicycles and Ireland a CA in computers. Ireland has an
Absolute Advantage in both. Note that while cannot you quite draw the PPCs for
Ireland and China from the information provided, one can see what their slopes would
be like. China (AB)is shown below:
1
Computers
A
IRL
O
B
Bicycles
OB is 5 times the number represented by OA. For Ireland OB would be twice OA and
the PPC would have a slope like the dotted line IRL
1MCQ 1: Comparative Advantage:
(a) is relevant only when there is complete free trade between countries
(b) is not as important as absolute advantage.
(c) is based on the opportunity cost principle
(d) is only relevant if one has an absolute as well as a comparative advantage
(e) none of the above is true.
(c ) is correct. CA is relevant even when considering purely domestic specialization,
as when two people produce different goods and swap them. CA is arguably more
important than Absolute advantage, depending on the point one is trying to argue; it is
certainly more important when it comes to arguments about trade.
1MCQ 2: My gas bill depends on a fixed charge of 15 per month as well as the
amount of gas consumed, which is charged at 2 per m3. It is proposed to abolish the
fixed charge and to increase the charge per m3 to 3 in order to encourage energysaving. How much gas would I have to use per month for this change save me money?
(a) 13 m3 or less
(b) 14 m3 or less
(c) 15 m3 or less
(d) 16 m3 or less
(e) impossible to say
The right answer is (c): 15 m3 or less. Why? Clearly those who use small amounts
stand to benefit from the abolition of the fixed charge which costs them a lot per m 3.
The cost (C ) is: C = A + bY, where A is the fixed charge, b the price per m3 , and Y
the number of m3s consumed. Under the old regime C = 15 + 2Y; under the new
regime C = 3Y. Breakeven is therefore when 15 + 2Y = 3Y, i.e. when Y = 15, so one
saves if consumption is < 15 m3 .
1MCQ 3: One of the following statements is not falsifiable:
(a) The government should control the price of petrol
(b) When there is a negative supply shock the price of oil will fall.
(c ) When there is a negative supply shock the price of oil could rise, fall or stay the
same
(d) High oil prices are unfair
(e) High oil prices may or may not last
2
(b) is correct. First you can eliminate (a) and (d): any statement with ought or
assertion of unfairness is likely to be a value judgment, and something which
cannot be refuted purely empirically (i.e by appealing to the facts). That leaves (a),
(c ) and (e). We can eliminate (c ) and (e) because they say anything can happen, so
no possible outcome can prove them false. That leaves (a), which can clearly be
shown to be wrong if we can get evidence that negative shocks to oil supply lead to
increases (not falls) in the price.
Note: The MCQs should be answerable very quickly, especially Nos 1 and 3. No 2
takes a bit of working out, but not much: its a matter of thinking about the nature of
the problem and setting it up and solving it. Also, while the non-MCQ questions are
not the same as any formal exam or test for this course, your ability to answer them is
a good indicator of your ability to answer several possible MCQs which might be
based on the same concepts.
3